"The mark of a well educated person is not necessarily
in knowing all the answers, but in knowing where to find them."

—— Douglas Everett.

Here you will find relatively brief articles and papers, each of which
focuses on a fairly narrow topic. For more broad coverage of investing
issues, see our Reading Room for Books.

We've listed herein a mix of good articles from the popular press (intended for
lay people) and highly technical academic papers. Hopefully, these
materials will elucidate more than they confuse. We've included links for the vast
majority of the entries. Note that some of the papers are quite lengthy
and may take a fair amount of time to download.

Unfortunately, some papers aren't freely available on the Internet at this
time (to the best of our knowledge). You may be able to find them at large
public libraries. You almost certainly will be able to locate them at most
business school libraries. For those papers which aren't freely available
online, we've tried to include brief summaries.

Articles written in a fashion such that laypeople can
probably understand them are colored blue
— most people should be able to
comprehend them. Technical articles and
papers intended for professionals/academics are colored red.

If you have questions or comments about any of the materials referenced here, contact us — we love
talking about this stuff!

Asset allocation refers to the division of one's investment portfolio across
the various asset classes. At the highest level, this refers to a split
between stocks and bonds. Many more finely defined sub-asset allocations
are also common. Also, see Modern
Portfolio Theory, Rebalancing and
Tax-Managed Investing.

Ian Ayres and Barry J. Nalebuff, "Diversification
Across Time," Yale Law & Economics Research Paper No. 413,
Oct 4, 2010. This outstanding paper discusses the idea of
spreading one's stock exposure more evenly across their lifetime, which
should then reduce the riskiness surrounding the ending wealth.
Here's an excellent website
where the authors discuss this idea.
Here's the outstanding book where they elaborate in depth on this idea.

Gary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, "Determinants
of Portfolio Performance," Financial Analysts Journal, July/August
1986, pp. 39-44. This was the paper which revolutionized
portfolio construction by emphasizing the importance of asset allocation.
It found that, on average, 93.6% of the total return variation of the pension funds studied
over time was due solely to asset allocation. Further, it found that active
management resulted in an annual reduction of 1.1 percentage points in total
returns.

Gary P. Brinson, Brian D. Singer, and Gilbert P. Beebower, "Determinants
of Portfolio Performance II: An Update," Financial Analysts Journal,
May/June 1991, pp. 40-48. "Clearly, the contribution of
active management [which was found to be somewhat negative] is not
statistically different from zero." An update of their previous work, with similar
conclusions.

Natalie Chieffe, "Asset Allocation, Rebalancing, and
Returns," Journal of Investing, Winter 1999, pp. 43-48.
"The results of this research show that market conditions tend not to
provide reliable information on which to base the rebalancing decision
[i.e., tactical asset allocation decisions]. Much of the advice
presented to investors during periods of unusual market activity should be
ignored. It is more important to rebalance the retirement portfolio on
the basis of a change in risk aversion, rather than on the conditions in the
financial markets."
Basically, this paper supports the idea of strategic, not tactical, asset
allocation.

Wolfgang Drobetz and Friederike Köhler,
"The
Contribution of Asset Allocation Policy to Portfolio Performance,"
WWZ/Department of Finance Working Paper No 2/02 (115kb). "...
active management not only failed to add value above the policy benchmarks
[but] it destroyed a significant portion of investors' value." This
paper concludes that asset allocation accounts for about 134 percent of the
level of portfolio performance (implying that active management accounts for
about minus 25%).

Eugene F. Fama and G. William Schwert, "Asset
Returns and Inflation," Journal of Financial Economics, November
1978, pp. 115-146 (1.49mb). For a smaller file version, see
here (749kb).
This paper studies the relative efficacy of various asset classes as inflation
hedges. It finds that treasury bonds are a complete hedge against
expected inflation. It also finds that private residential real estate
is a complete hedge against both expected and unexpected inflation.

Roger C. Gibson, "The
Rewards of Multiple-Asset-Class Investing"
Journal of
Financial Planning, July 2004, pp. 58-71. Another outstanding version of his timeless message,
reprinted from its original appearance in this Journal in March 1999.

Sherman Hannah and Peng Chen, "Subjective
and Objective Risk Tolerance: Implications for Optimal Portfolios,"
Financial Counseling and Planning Journal, Vol 8 No 1 1997, pp. 17-26.
"For a typical investor under the age of 50, a retirement savings portfolio
should be 100% in stocks." This paper attempts to make suggestions
primarily based on need and ability to bear risk ("objective risk"), but not
very much on willingness to bear risk ("subjective risk"). In
general, we do not agree with the 100% stock asset allocation recommendation
except in cases where there is a very high willingness and ability to tolerate
risk.

Kwok Ho, Moshe Arye Milevsky, and Chris Robinson,
"Asset Allocation, Life Expectancy, and Shortfall," Financial Services
Review, 3(2) 1994, pp. 109-126. Also
here. This study suggests that, in
order to minimize shortfall risk, it may be appropriate for investors to
maintain 100% stock allocations well into their retirements (i.e., as late as
age 75 for men and 80 for women). In general, we do not agree that most
retirees should use such a high stock allocation unless they have a very high
willingness and ability to tolerate risk.

David Nawrocki, "The
Problems with Monte Carlo Simulation," Journal of Financial Planning,
November 2001, pp. 92-106. Also
here. Also
here. This excellent article puts Monte
Carlo simulations into perspective. Consumers are increasingly being led
to believe that use of a Monte Carlo simulator accurately projects the
probability of meeting their financial goals. The article correctly
exposes this fraud. We believe that Monte Carlo simulators may be useful
in educating clients about the nature of risk and return tradeoffs, but they
certainly shouldn't be counted on to determine one's asset allocation.
The principal problem with them is that the entire analysis depends solely on
the validity of the data inputs as predictors of the future.
Unfortunately, there is only one thing we know for certain about those inputs,
whatever they might be: they are wrong. We don't know how wrong they are
or whether they overstate or understate the future, but we are 100% certain that they
are wrong. Good bibliography at the end and good sidebar by John
Kingston.

André F. Perold and
William F. Sharpe, "Dynamic Strategies for Asset Allocation," Financial
Analysts Journal, January/February 1988, pp. 16-27. This
paper studies three dynamic asset allocation strategies: Buy-and-hold,
portfolio insurance (both constant proportion and options-based), and
constant-mix. The paper concludes that each might be most appropriate in
certain market conditions or for certain clients. We believe that the
constant-mix strategy is most appropriate for most individual investors in
that it controls the amount of risk in the portfolio. Controlling risk
not only controls expected return, but it tends to preclude investors from
allowing well-documented psychological phenomena
to influence them to do
things which are adverse to their financial well-being.

James M. Poterba, "Valuing Assets in Retirement
Saving Accounts," National Tax Journal, June 2004, pp. 489-512. This
paper builds on the Reichenstein and Sibley papers below.

A fixed-weight strategy takes little time and it can save time at tax
time.

Paul A. Samuelson, "The Long-Term Case for
Equities: and how it can be oversold," Journal of Portfolio Management, Fall 1994, pp.
15-24.
This paper, written by a Nobel prize winner, warns against market timing,
warns against active management, and generally supports the prudence of
strategic asset allocation.

Paul A. Samuelson, "Asset allocation could be
dangerous to your health: Pitfalls in across-time diversification," Journal
of Portfolio Management, Spring 1990, pp. 5-8. This paper,
written by a Nobel prize winner, warns against tactical asset
allocation (and is consistent with the prudence of strategic asset
allocation).

Mike Sibley, "On
the Valuation of Tax-Advantaged Retirement Accounts," Financial
Services Review, 11 (2002), pp. 233-251 (726kb). An excellent discussion of
how to get an after-tax valuation for a retirement account. Due to the
assumption made that the taxable equivalent investment is perfectly tax
inefficient, the equations' applicability is limited only to valuing bond
investments.

Steve Strongin and Melanie Petsch, "Protecting
A Portfolio Against Inflation Risk," Investment Policy, July/August
1997, pp. 63-82 (439kb). An excellent discussion of how to hedge
against various types of inflation risk. It suggests that international
diversification, inflation-indexed bonds, and commodities are the best hedges
against inflation.

Ronald J. Surz, Dale Stevens, and Mark Wimer, , "The
Importance of Investment Policy,"
Journal of Investing, Winter 1999, pp. 80-85. "We find that, on average, policy [a.k.a., asset
allocation] explains approximately 100% of investment returns. If a manager
succeeds in adding value, this can drop to as low as 85% when risk is not
incorporated, and even to 75% on a risk-adjusted basis. If the manager fails to add value, policy can explain as much as 135% of
return unadjusted for risk, or 165% risk-adjusted; the difference between
these percentages and 100% is explained by manager value reduced through
market timing, selection, and/or costs. In other words, if a manager
neither adds nor reduces value, policy explains 100% of performance."

Ronald J. Surz, Dale Stevens, and Mark Wimer, "The
Importance of Investment Policy: A Simple Answer to A Contentious Question,"
PPCA. "We find that, on average, policy [a.k.a., asset
allocation] explains approximately 100% of investment returns. If a manager
succeeds in adding value, this can decrease to as low as 85% when risk is not
incorporated, and even further to 75% on a risk-adjusted basis. On the other
hand, if the manager fails to add value, policy can explain as much as 135% of
return unadjusted for risk, or 165% risk-adjusted ..."

Yesim Tokat, "The
Asset Allocation Debate: Provocative Questions, Enduring Realities,"
Investment Research and Counseling /ANALYSIS, April 2005. A
summary of the issues. "Unless there is a strong belief in the
ability to select active managers who will deliver higher risk-adjusted net
returns, investors’ focus should be on the asset allocation choice and its
implementation using broadly diversified, low-cost portfolios with limited
market-timing."

Yesim Tokat, Nelson Wicas, and Francis M. Kinniry, "The
Asset Allocation Debate: A Review and Reconciliation,"
Journal of Financial Planning, October 2006, pp. 52-63. A
summary of the issues. "Unless there is a strong belief in the
ability to select active managers who will deliver higher risk-adjusted net
returns, investors’ focus should be on the asset allocation choice and its
implementation using broadly diversified, low-cost portfolios with limited
market-timing."

R. Douglas Van Eaton and James A. Conover, “Equity
Allocations and the Investment Horizon: A Total Portfolio Approach,”
Financial Services Review, 11(2) Summer 2002, pp. 117-133 (1.65mb).
This article provides support for the idea that an investor's equity exposure
should be somewhat proportional to their time horizon (actually it should be
somewhat proportional to the ratio of existing assets to future savings).

All securities bought or sold on exchanges have a bid-ask spread. This
is the difference between the security's selling price and its buying price.
The difference covers the costs and profits of the market maker. Whenever
you buy or sell a security on an exchange, you implicitly incur one-half of the
bid-ask spread as a transaction cost. Also, see
Illiquidity Premium.

Kidwell, Blackwell, Peterson, and Whidbee, "Financial
Institutions, Markets, and Money," John Wiley & Sons. This
slide presentation summarizes Chapter 10 of the referenced book. The
highlight as it applies to this topic: In general, bid-ask spreads:

are proportionately higher for low-priced stocks due to fixed costs of
operations.

are higher for trades of a few shares.

are higher for a large block trade; a liquidity service is performed.

are narrower with more frequent trading, where the costs of providing
liquidity are less.

are wider with traders with insider information, where the dealer may
have to incur the cost of price discovery, or buying high, selling low!

Jinbaek Kim, "A
Study on the Bid-Ask Spread," U.C. Berkeley
Working Paper.The appendices here
are outstanding. They summarize the important existing research on the
bid-ask spread.

Hans Stoll, "Inferring the Components of the Bid-Ask
Spread: Theory and Empirical Tests," Journal of Finance, March 1989,
pp. 115-134. See
here for
a good discussion of this paper. This paper finds that serial
return covariances are strongly negatively correlated with the square of the
bid-ask spread. Further, the paper finds that the bid-ask spread can be
broken down empirically into the following components:

Fixed income assets (e.g., bonds) are often added to a portfolio to lessen
its volatility. Another benefit from including bonds in a (otherwise all
equity) portfolio is the improved risk/return characteristics resulting from the
less than perfect correlation of bonds with equities and other assets.
Also, see Inflation-Indexed Bonds and
High-Yield Bonds (Junk Bonds).

Vance Anthony, Martha Mahan Haines, and Murat
Aydogyu, "Report
on Transactions in Municipal Securities," United States Securities and
Exchange Commission, July 1 2004 (2.3mb). This excellent study
quantifies the extent of typical bid-ask spreads for individual municipal
bonds (they're big). The bid-ask spread is effectively a transaction
cost. Effectively, any time you buy or sell a municipal bond, you pay
one-half of the bid-ask spread as a transaction cost, perhaps in addition to a
brokerage commission. For a good discussion of this study, see the Zweig
article below.

Manoj V. Athavale and Terry L. Zivney, "Now
is Always the Best Time to Buy Bonds,"
Journal of Financial Planning, August 2005, pp. 56-61. This
outstanding paper suggests that it makes sense to buy bonds when you need
them, even if that happens to be in a rising interest rate environment.
"... financial planners would better serve their clients by helping them
define their investment time frame and helping them understand the role of
bonds in their portfolio, and discouraging speculation on the direction and
magnitude of interest rate changes."

Christopher R. Blake, Edwin J. Elton, Martin J.
Gruber, "The Performance of Bond Mutual Funds," Journal of Business,
July 1993, pp. 371-403. This study concludes, "Overall and
for subcategories of bond funds, we found that bond funds underperformed
relevant indexes. ... this underperformance was approximately equal to
the average management fees ..." "... on average, a percentage point
increase in expense leads to a percentage point decrease in returns ..."
This paper strongly supports the prudence of a strategy of selecting bond
funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

Dale L. Domian, Terry S. Maness, and William
Reichenstein, "Rewards to Extending Maturity: Implications for investors,"
Journal of Portfolio Management, Spring 1998, pp. 77-92. This
paper confirms that short term bonds offer superior risk-adjusted returns to
those offered by longer term bonds. "The average term premium appears
to rise very sharply as maturity lengthens through about one year, continues
to rise through about three years, remains essentially flat from. about three
through fifteen years, and falls thereafter." "The greatest reward to
risk is realized for extending maturity through the shortest end of the bond
market. In fact, most of the average reward to extending maturity probably
occurs by the time maturity reaches one year."

Amy K. Edwards, Lawrence E. Harris, and Michael S.
Piwowar, "Corporate
Bond Market Transaction Costs and Transparency," Journal of
Finance, June 2007, pp.
1421-1451. "Our results show that corporate bonds are
expensive for retail investors to trade. Effective spreads in
corporate bonds average 1.24% of the price of representative retail-sized
trades ($20,000). ... Corporate bond transaction costs are much lower for
institutional-sized transactions." This paper confirms the
prudence of using bond funds instead of individual bonds -- due to the much
higher transaction costs associated with retail-size trades.

Edwin J. Elton, Martin J. Gruber, Deepak Agrawal,
and Christopher Mann, "Explaining
the Rate Spread on Corporate Bonds," Journal of Finance, February
2001, pp. 247-278 (219kb). This paper studies the factors which
influence the difference between returns on corporate bonds and government
bonds. They found that the possibility of default for corporates
explains about 18% of the difference. They also found that the
tax-exempt treatment of government bonds at the state and local level explains
about 36% of the difference. Of the remaining effects, about 85% is
explained by factors which are commonly used to explain common stock returns.

Cheol S. Eun and Bruce G. Resnick, "International
Diversification of Investment Portfolios: U.S. and Japanese Perspectives,"
Management Science, January 1994, pp. 140-161. "For U.S.
investors, the international bond diversification with exchange risk hedging
offers a superior risk-return trade-off than the international stock
diversification, with or without hedging." This paper supports the
prudence of hedging the currency risk on foreign bond investments.

Eugene F. Fama and Robert R. Bliss, "The Information
in Long-Maturity Forward Rates," American Economic Review, September
1987, pp. 680-692. This paper suggests that long forward interest
rates have significant power in predicting future spot interest rates.
"The 1-year forward rate calculated from the prices of 4- and 5-year bonds
explains 48 percent of the variance of the change in the 1-year interest rate
4 years ahead." In other words, the market is fairly efficient at
anticipating future interest rates.

Eric E. Haas, "Corporate
Bond Fund or Individual Treasuries: Which is Better?," Altruist
Financial Advisors LLC Working Paper, May 4 2005. This paper
quantitatively answers the question, "Which is better for an individual
investor: A bond fund or individual bonds?" As you might imagine, the
answer ultimately is, "It depends." But basically, this paper suggests
that, over the period studied (85-02), a short-term investment grade corporate
bond fund would have outperformed, on a risk-adjusted basis, a portfolio of
individual treasury bonds, if the difference in its fees were less than about
0.71 percentage points. Since such funds are generally available (e.g.,
the Vanguard Short-Term Investment Grade Fund (VFSTX)), it seems prudent for
most individual investors to go the bond fund route.

Delroy Hunter and David P. Simon, "Benefits
of International Bond Diversification," Journal of Fixed Income,
March 2004, pp. 57-68 (1mb).
This paper finds that, during the period 1992 to 2002, there was benefit to
diversifying a bond portfolio overseas, but only if you hedged the currency
risk.

Antti Ilmanen, "Does
Duration Extension Enhance Long-Term Returns?," Journal of Fixed
Income, September 1996, pp.
23-36. "The main conclusion is that duration extension does
increase expected returns at the front end of the [yield] curve ... and
for durations longer than two years, no conclusive evidence exists of rising
expected returns."

Antti Ilmanen, Rory Byrne, Heinz Gunasekera, and
Robert Minikin, "Which
Risks Have Been Best Rewarded?: Duration, equity market, and short-dated
credit risk," Journal of Portfolio Management, Winter 2004, pp.
53-57. This outstanding paper looks at what return
enhancing strategies are most "worthwhile" for bond investors: extending
duration, changing from bonds to stocks, and decreasing credit quality.
It finds that the highest increase in risk adjusted returns comes from
extending duration from treasury money market to the 1 to 3 year range, and
from increasing credit risk from zero (Treasuries) to investment-grade corporates. This paper supports a strategy of using short-term
investment grade corporate bonds as the (non-inflation indexed) bond component in your
portfolio.

Alexander Kozhemiakin, "The Risk Premium of
Corporate Bonds," Journal of Portfolio Management,
Winter 2007, pp. 101-109. "If investors are concerned
primarily with generating the best risk-adjusted returns, the shape of the
risk premium curve will promote investment-grade bonds. ... This also
implies that 1) ensuring proper diversification and 2) reducing transaction
costs are of more importance in managing investment-grade portfolios than a
detailed credit analysis of individual bonds." This paper
supports the idea that concentrating on investment grade bonds (i.e., rather
than on lower-quality debt) seems prudent for most investors.

Haim Levy and Zvi Lerman, "The Benefits of
International Diversification in Bonds," Financial Analysts Journal,
September/October 1988, pp. 56-64. "There appears to be a very
large potential for international diversification in stocks and bonds, even if
we qualify the expectation of possible gains by recognizing the possible extra
costs associated with holding foreign investments."

Burton G. Malkiel, "Expectations, Bond Prices,
and the Term Structure of Interest Rates,"
Quarterly Journal of Economics, May 1962, pp. 197-218.
This seminal paper laid out clearly some of the principal phenomena affecting bond
pricing.

Craig McCauley, "The Case for Global Fixed Income,"
Global Investor, October 1996, pp. 29-31. "...
presents a compelling case for US investors to
substantially increase their exposures to international fixed income markets
(on a fully hedged or unhedged basis), and to maintain a permanent exposure to
this asset class."

Robert C. Merton, "On
the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
May 1974, pp. 449-470 (1.58mb). This paper suggests that
corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a
put (i.e., an option to sell the stock) that bondholders issue to the owners
of the company’s stock. As the company's prospects become better, the
stock's price increases, which causes the value of the put to decrease (which
is good for the bondholders who issue the virtual puts), which causes the
value of the bond to increase, which causes the yield on the bond to decrease.
On a separate line of thought, as the company becomes riskier, the value of
the put increases (which is bad for the bondholders who issue the virtual
puts), which causes the value of the bond to decrease, which causes the yield
on the bond to increase. This is how high-yield bonds get to be
high-yield bonds!

Frederick S. Mishkin, "The Information in the Term
Structure: Some Further Results," Journal of Applied Econometrics,
Oct-Dec 1988, pp. 307-314. "The term structure does help predict
spot interest rate movements several months into the future." This
paper provides additional support for the prudence of DFA's "variable
maturity" strategy.

Alejandro Murguía and Dean T. Umemoto, "Analyzing
Fixed-Income Securities and Strategies," Journal of Financial Planning,
November 2005, pp. 80-90. A good discussion of issues
around investing in bonds.

Eugene A. Pilotte and Frederick Sterbenz, "Sharpe
and Treynor Ratios on Treasury Bonds," Journal of Business,
January 2006. "Most
striking is our finding that reward-to-risk ratios vary inversely with
maturity and are incredibly high for short-term bills. Apparently investors
would do much better engaging in highly leveraged investments in bills instead
of purchasing long maturity bonds or common stocks." This
paper provides additional support for the prudence of keeping bond durations
short.

Tom Potts and William Reichenstein, "Predictability
of Fixed Income Fund Returns," Journal
of Financial Planning, November 2004. This paper finds
that relative bond fund returns are somewhat predictable. For funds with
similar duration and credit worthiness, the difference in returns is likely to
be similar to the difference in expense ratio. The gross returns for
Intermediate-Term bond funds were consistent (over five year periods, but less
so for shorter periods) with the yield on five year treasuries at the
beginning of the period. The gross returns for Long-Term bond funds were
consistent (over ten to twenty year periods, but less so for shorter periods)
with the yield on twenty year treasuries at the beginning of the period.

William Reichenstein, "Bond
Fund Returns and Expenses: A Study of Bond Market Efficiency," Journal
of Investing, Winter 1999, pp. 8-16 (488kb). This paper finds
a strong persistence in bond fund performance. It suggests this is due
to the strong negative correlation between a bond fund's expenses and its
performance. In other words, this paper suggests that selecting bond
funds by price (i.e., no-load funds with the lowest expense ratios) is an
extremely prudent strategy.

Sandeep Singh and William H. Dresnack, "Market
Knowledge in Managed Municipal Bond Portfolios," Financial Services
Review, 6(3), pp. 185-196. "This study provides further
support in favor of indexing." "When state income taxes are considered
significant, for example, in states like New York and California, it is
beneficial for the individual investor to buy into state-specific municipal
bond funds." The paper found that state-specific muni-bond funds were
riskier than national funds, but they offered superior risk-adjusted after-tax
returns.

Broker/Dealers are involved with selling financial products and executing
brokerage transactions (as opposed to
providing objective advice as a fiduciary). Sadly, the public is
ill-informed about the conflicts of interest exhibited by Broker/Dealers and
subsequently tend to accept sales-pitches masquerading as objective financial
advice as such objective financial advice.

Daylian M. Cain, George Lowenstein, and Don A.
Moore, "The
Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest,"
Journal of Legal Studies, Vol 34 (2005), p 1.
This outstanding study shows that even if Broker/Dealers plainly disclose
their inherent conflict of interest, the consumer might actually be worse off
than if the disclosure didn't happen. This study confirms the prudence
of requiring fiduciaries to avoid, rather than merely disclosing, conflicts of
interest. "Conflicts
of interest can lead experts to give biased advice. While disclosure has been
proposed as a potential solution to this, we show that disclosure can have
perverse effects, and might even increase bias. Disclosure may increase bias
because advisors feel morally licensed and strategically encouraged to
exaggerate their advice even further from the truth. As for those receiving
the advice, proper use of the disclosure depends on understanding how the
conflict of interest biased the advice and how that advice impacted them.
Because people lack this understanding, disclosure can fail to solve the
problems created by conflicts of interest."

The Capital Asset Pricing Model was developed in the mid-60s by William
Sharpe, John Lintner, and Jan Mossin (independently). Some believe that
its utility has largely been eclipsed by the introduction of the
Fama/French Three-Factor Model.

Eugene F. Fama and Kenneth R. French, "The
Capital Asset Pricing Model: Theory and Evidence," CRSP Working Paper 550,
January 2004 (105kb). Also
here.
This excellent paper discusses some of the major problems with the CAPM.
"The problems are serious enough to invalidate most applications of the
CAPM" "... despite its seductive simplicity, the CAPM's empirical
problems probably invalidate its use in applications."

Eugene F. Fama and Kenneth R. French, "Disagreement,
Tastes, and Asset Prices," CRSP Working Paper 552, February 2004 (89kb).
Also here.
This paper discusses the implications of one of the assumptions of the CAPM
—
that there is complete agreement among investors about probability
distributions of future payoffs on assets.

Charitable Giving has several benefits. First, of course, it is good
for the soul. But many don't realize how it can have enormously beneficial
tax effects as well. For example, if, instead of donating cash, you donate
highly appreciated securities, you can avoid paying capital gains taxes on those
securities (and the charity wouldn't have to pay them either). This is in
addition, of course, to the benefit of the tax-deduction you get for charitable
gifts of any kind.

Roccy DeFrancesco, "Gifts
That Keep Giving," Financial Planning, July 2004, pp. 89-92.
A good article which goes into detail about one way to use a Charitable Gift
Annuity in conjunction with a Donor-Advised Fund and a Irrevocable Life
Insurance Trust.

Closed End Funds are mutual funds which are bought and sold on exchanges
(i.e., like you buy and sell stocks). Interestingly, the share price,
determined by the market, can dramatically differ from the share price
determined by the current value of the securities a closed end fund holds (i.e.,
its NAV). This gives an investor the opportunity to get exposure to
securities at a deep discount. Whether or not it is prudent to do so is a
different story. Before going out and buying discounted closed-end funds,
be sure to read the Pontiff and Reichert/Timmons papers below.

Dominic Gasbarro, Richard D. Johnson, and J. Kenton
Zumwalt, "Evidence on the Mean-Reverting Tendencies of Closed-End Fund
Discounts,"
The Financial Review, May 2003, pp. 273-291. This paper
examines the "mean-reverting" tendency of closed-end funds.
Specifically, it examines the hypothesis that funds sold at a discount to NAV
tend to have their discount narrow (i.e., the fund share price tends to
increase towards NAV over time). The truth of this hypothesis is
important for investors who desire to engage in closed-end fund arbitrage.

Burton G. Malkiel, "The Valuation of Closed-End
Investment Company Shares,"
Journal of Finance, June 1977, pp. 847-859. This paper
suggested that it seemed possible to get significant abnormal positive returns
through investing in deeply discounted closed-end funds. Specifically,
this paper found at least two reasons to consider deeply discounted closed-end
funds:

The expected returns on a deeply discounted closed-end fund are much
higher than the expected returns on a similar portfolio of the underlying
securities. Even if the discount doesn't narrow, you get all of the
income from the underlying securities with a fraction of the up-front
investment.

Fund discounts seem to narrow when the market falls and increase when the
market rises. This suggests that closed end funds might make good
diversifiers, all else being equal.

Jeffrey Pontiff, "Excess Volatility and Closed-End
Funds,"
The American Economic Review, March 2003, pp. 155-169. This interesting
paper finds that the prices of closed end funds are about 64 percent more
volatile than the assets they hold. This is yet another reason to think
twice before attempting a closed end fund arbitrage strategy.

Carolyn Reichert and J. Douglas Timmons, "Closed-End
Investment Companies: Historic Returns and Investment Strategies,"
The Financial Review, May 2003, pp. 273-291. Also
here. This interesting
paper models the results of a simple investment strategy designed to take
advantage of the presumed tendency of a closed-end fund (which is trading at a
discount) to have its discount lessen over time. Specifically, this paper
analyzes a strategy of buying the closed-end funds with the greatest discount,
holding them for one year, then replacing them with the funds which a year
later are available at the greatest discount. This paper's conclusion: "The
results do not support the use of a simple mechanical strategy. Even
when marginally significant before-tax returns are available, transaction
costs and taxes erode the benefits. Excess returns are not possible for
investors lacking the time or resources to actively trade in the marketplace.
Small investors following simple trading rules with a minimum of rebalancing
are unlikely to earn the abnormal returns documented in earlier studies.
This should serve as a warning to investors lured by the promise of excess
returns from CEIC [Closed-End Investment Company] funds selling at
discounts. It is important for small investors to be aware of the need
for additional monitoring, more frequent trading, larger initial investments,
or short selling if they want to use CEIC funds to outperform the market.
Investors wanting to avoid these complications should consider alternative
investments."

Rex Thompson, "The information content of discounts
and premiums on closed-end funds," Journal of Financial Economics, 6,
pp. 151-186. Thompson finds that a relatively simple trading rule
(based on discounts for closed-end funds) earned statistically significant
abnormal returns of about 4% per year over the period 1940-1971. In addition,
the results are quite uniform throughout the period.

There are several tax-advantaged means of saving for college. For most
people, 529 savings plans are the best choice. If your state offers
tax-deductions for contributions to your state's plan, you should consider (the
direct purchased version of) that plan (i.e., don't buy it through a financial
adviser). Otherwise, you should consider one of the low cost alternatives:
Colorado,
Iowa,
Michigan,
Minnesota, Missouri,
Nebraska,
Nevada (Vanguard), New York,
Ohio,
Utah or
Virginia (note that Nebraska's
and New York's plans offer significantly greater investing flexibility than the others).
Utah's plan is definitely the least expensive of
the bunch, followed closely by Ohio's
and
Virginia's. Note that
West Virginia's SMART529 Select plan,
while not being among the lowest cost plans, has the best investment choices and
may be the best value, especially for very young beneficiaries (for information
on what makes a "good" investing choice, see here). For information on all 529 plans,
see SavingforCollege.com.
Note that, if you choose another state's plan, it may be necessary to transfer
it back to your state's plan immediately before college in order to avoid
taxation of withdrawals by your state.

Barry Marks and William Reichenstein, "Tax
Strategies for Financing Higher Education," Journal of Financial
Planning, May 2000. The authors survey the various means of
saving for college education. Note that this article preceded the vast
tax law changes enacted in 2001.

Commodities refers to real assets such as energy, agriculture, livestock,
industrial metals, and precious metals. The below papers make a compelling
case for the diversification benefits of collateralized commodities index
futures contracts (i.e., they have a very low correlation with other asset
classes). Unfortunately, there are few practical means for retail
investors to prudently expose themselves to this asset class. We currently
recommend the DFA Commodity Strategy Portfolio (DCMSX) as the preferred means of
implementing this asset class. If you don't have access to DFA funds
(Altruist clients do), you might consider the PowerShares DB Commodity Index
Tracking Fund (DBC).

In general, we would recommend only a fairly small fraction of any portfolio
be allocated to this asset class. Further, since futures contracts (and
derivatives thereof) tend to
be quite tax-inefficient, these investments are generally best held in tax-exempt
accounts.

Mark J. P. Anson, "Maximizing Utility with Commodity
Futures Diversification," Journal of Portfolio Management, Summer 1999,
pp. 86-94. "This research demonstrates that commodity futures,
when considered in their proper portfolio context, are a valuable asset class
for risk-averse investors. Because of their excellent diversification
potential over long periods of time, commodity futures are found to have
greater utility, the more risk-averse the investor."

Zvi Bodie and Victor I. Rosansky, "Risk and Return
in Commodity Futures," Financial Analysts Journal, May/June 1980, pp.
27-38. This paper studied the period 1950 to 1976. During
that time, it found that commodity futures had stock-like returns, but very
low correlation with stock returns (which makes it a good diversifier for
stocks). It found that a portfolio consisting of 60% stocks and 40%
commodity futures would have had the same long term returns as an all-stock
portfolio with one third the volatility.

Burak Cerrahoglu and Barsendu Mukherjee, "The
Benefits of Commodity Investment," Center for International Securities and
Derivatives Markets, March 2003 (253 kb). "Adding a commodity
component to a diversified portfolio has been demonstrated to result in
enhanced risk-adjusted performance."

Georgi Georgiev, "Benefits
of commodity investment," Journal of Alternative Investments,
Summer 2001, pp. 40-48 (247kb). "Adding a commodity component to a
diversified portfolio of assets has been demonstrated to result in enhanced
risk-adjusted performance."

Gary B. Gorton and K. Geert Rouwenhorst, "Facts
and Fantasies about Commodity Futures," NBER Working Paper 10595, June
2004 (704kb). Also here.Here's a good
discussion of this paper. "Fully-collateralized commodity futures have
historically offered the same return and Sharpe ratio as equities. While the
risk premium on commodity futures is essentially the same as equities,
commodity futures returns are negatively correlated with equity returns and
bond returns. The negative correlation between commodity futures and the other
asset classes is due, in significant part, to different behavior over the
business cycle. In addition, commodity futures are positively correlated with
inflation, unexpected inflation, and changes in expected inflation."

Gary B. Gorton, Fumio Hayashi, and K. Geert Rouwenhorst, "The
Fundamentals of Commodity Futures Returns", Yale ICF Working Paper 07-08
and NBER Working Paper W13249, June
2007 (940kb). Also
here
and here. This paper examines the source of risk premiums for
commodities futures and distinguishes it from the theory of normal
"backwardation."

Robert J. Greer, "The
Nature of Commodity Index Returns," Journal of Alternative Investments,
Summer 2000, pp. 45-52 (261kb). An excellent paper examining the
nature of Commodities as an asset class. The author concludes that
commodities have returns similar to those of equities, that commodities are
negatively correlated with stocks and bonds, and that commodities are
positively correlated with inflation.

Thomas M. Idzorek, "Strategic
Asset Allocation and Commodities," Ibbotson Associates, March 27 2006.
Also
here. This study found that including collateralized commodities futures in a
strategic asset allocation had a strong tendency to increase risk adjusted
returns both using historical data and conservative forecasted simulations.

"The Benefits
of Commodity Investment 2005 Update," Center for International
Securities and Derivatives Markets,
June 2005. "Adding a commodity component to a diversified
portfolio of assets has been demonstrated to result in enhanced risk-adjusted
performance. We believe that this research would place the use of investable
commodity indices as a central part of the institutional investors’ asset
allocation decision."

When investing in foreign investments, an investor subjects herself to
currency risk (i.e., the changes in the value of the investment due solely to
changes in the exchange rate between the investor's native currency and that of
the country where the investment is domiciled). Some investors choose to
hedge (i.e., eliminate) this risk by buying currency futures for the
investment's currency. Also, see Foreign
Investing.

Data Mining (a.k.a., "Data Snooping") refers to the practice of searching through data looking for
patterns. Of course, there isn't anything wrong with that, in general.
However, many make the mistake of finding apparent patterns in the sample (which
may be due to chance) and inappropriately extrapolating
them from the sample to the data universe. That's a fancy way of saying
that if you find a pattern in past financial data, it may be that the pattern
existed solely due to chance, even if it strongly appears otherwise.

Grant
McQueen and Steven Thorley, "Mining Fool's Gold," Financial Analysts
Journal, March/April 1999 pp. 61-72. This paper tests
several strategies advocated by The Motley Fool. After proving the
imprudence thereof, they go farther to discuss the larger topic of data
mining — how to detect it and how to avoid it. An excellent article.
Here's a summary of their guidance:

The more variables involved, the
more likely the strategy worked just by chance.

Rules that are built on other
rules (which didn't stand the test of time) are guilty of intergenerational
mining.

A plausible and reasonable theory
why the strategy works is far more important than simply knowing that it did
work. When judging plausibility, the competitive nature of investing
must be kept in mind. Theories or explanations based on the idea that
market participants are dumb, lazy, or myopic are not to be trusted.

Successful strategies should
stand up to out-of-sample testing.

Never be impressed by unadjusted
returns. Many trading rules that yield high nominal returns come at a
price, often in the form of increased risk, higher transaction costs, and/or
higher taxes. You need to correct for these in order to do a fair
comparison with alternative strategies.

Any popular investment strategy
or rule tends to fall victim to its own success.

Schlomo Benartzi and Richard H. Thaler, "Naive
Diversification Strategies in Defined Contributions Pension Plans,"
American Economics Review, March 2001, pp. 79-98 (217kb).
This paper finds that defined contributions pension plan participants tend to
split their investments evenly among all investment choices. Thus, if
most of the choices are bond funds, people would tend to mostly invest in bond
funds. This finding should be an important consideration for fiduciaries
as they choose a plan's investment options.

James J. Choi, David Laibson, and Brigitte C.
Madrian, "Plan
Design and 401(k) Savings Outcomes," National Tax Journal Forum on
Pensions, 2004 (476kb). This paper surveys the impact of 401(k)
plan design on four different 401(k) plan savings outcomes.

Brooks Hamilton and Scott Burns, "Reinventing
Retirement Income in America," National Center for Policy Analysis Report
no. 248, December 2001 (196kb). This report, while suggesting some
legislative changes, also makes some recommendations which are implementable
now.

Richard H. Thaler and Schlomo Benartzi, "Save
More
TomorrowTM:
Using Behavioral Economics to Increase Employee Savings," Journal of
Political Economy, 112:1 2004, pp. 164-187 (128kb). This
paper details a prescriptive savings program which encourages saving.
The idea is that people commit in advance to allocating a portion of their
future salary increases towards retirement savings.

ERISA 404(c) Rules, US Department of Labor, October 13 1992.
This sets out the rules a plan must meet in order to meet the 404(c) safe
harbor (i.e., if you follow these rules, a plan sponsor is supposedly immune
from liability "... for any loss, or by reason of any breach, which results ....").

Diversification refers to the idea that your investments ought to be spread
out amongst many investments. On average, a diversified portfolio will
have the same expected return (but less risk/volatility) as a less diversified portfolio with similar
characteristics. When put that way, it is
easy to see why diversification is beneficial — why have a more risky portfolio
if you can't expect higher returns in exchange for taking on that additional risk?
Also, see the section on Modern Portfolio
Theory.

John Y. Campbell, Martin Lettau, Burton G. Malkiel,
and Yexiao Xu, "Have
Individual Stocks Become More Volatile? An Empirical Investigation of
Idiosyncratic Risk," Journal of Finance, February 2001, pp. 1-43
(1.95mb). This paper finds that, while several decades earlier,
it may have been true that adequate diversification could be had with 15-20
stocks, it is no longer true. The paper finds that, while volatility of
the stock market as a whole has remained relatively steady, the volatility of
individual stocks has increased. This implies that correlations between
stocks have decreased, which is confirmed by the paper's empirical results.
Thus, the benefits of diversification have increased, along with the need to
hold more stocks to achieve those benefits. This confirms the prudence
of holding highly diversified mutual funds instead of individual stocks.
Also, see the Picerno summary article below.

John L. Evans and Stephen H. Archer,
"Diversification and the Reduction of Dispersion: An Empirical Analysis,"
Journal of Finance, December 1968, pp. 761-767. This paper
largely covers the same ground as the Fisher/Lorie paper below, but this paper
only analyzed the period 1958-1967.

Lawrence Fisher and James Lorie, "Some Studies of
Variability of Returns on Investments in Common Stocks," Journal of
Business, April 1970, pp. 99-134. This is the paper usually
cited by those who claim that a portfolio of 16 or so randomly selected stocks
provides 90-plus percent of possible diversification benefit. This may
have been true in the 1926-1965 period studied, but as you can see from the
Campbell/Lettau/Malkiel/Xu paper above and the Surz/Price paper below, it no
longer appears to be true.

Zoran Ivković, Clemens
Sialm, and Scott Weisbenner, "Portfolio Concentration and the Performance of
Individual Investors," Journal of Financial and Quantitative
Analysis, September 2008, pp. 613-656. This paper finds
that individual investors with very concentrated portfolios tend to have
higher returns than investors with more diversified portfolios. This
counterintuitive observation seems to support undiversified portfolios.
However, while the undiversified portfolios had
(arithmetic) average returns that were 10% higher than diversified portfolios,
they also had 50% more risk/volatility! The
risk-adjusted returns of undiversified portfolios were dramatically smaller
than those of more diversified portfolios. So this paper actually
supports the prudence of diversification. The higher arithmetic
returns of an undiversified portfolio are likely to turn into lower geometric
returns due to the increased risk/volatility (and geometric returns are what
investors actually realize).

Henry A. Latané and
William E. Young, "Test of Portfolio Building Rules," Journal of Finance,
September 1969, pp. 595-612. "Diversification pays ... This
advantage of diversification results entirely from the reduction of variance
and hence increases in the geometric mean return. It is not necessary to
appeal to risk aversion on the part of investors to justify diversification."

Richard W. McEnally and Calvin M. Boardman, "Aspects
of Corporate Bond Portfolio Diversification," Journal of Financial Research,
Spring 1979, pp. 27-36. This paper analyzes how many individual
corporate bonds are necessary in order to obtain diversification benefits.
Its conclusion is that, for high-grade bonds, there is limited diversification
benefit, but that "something in the neighborhood of eight to 16 issues ...
appear adequate to eliminate diversifiable risk in bond portfolios."
Note that this paper is considering diversifying volatility risk, NOT credit
risk.

Meir Statman, "How
much Diversification is Enough?," Santa Clara University Working Paper,
September 2002 (308kb). "Lack of diversification is costly.
Investors who hold only 4 stocks in their portfolios forego the equivalent of
a 3.3% annual return relative to investors who hold the 3,444 stocks of the
Vanguard Total Index Stock Market Index fund. Why do investors forego
the benefits of diversification?"

Meir Statman and Jonathan Scheid, "Dispersion,
correlation, and the benefits of diversification," Santa Clara University Working Paper,
May 2004 (566kb). "Correlation is the common measure of the
benefits of diversification but it is deficient for two reasons. First, the
benefits of diversification depend not only on correlations but on standard
deviations as well. Dispersion combines both effects. Second, dispersion,
unlike correlation, provides an intuitive measure of the benefits of
diversification. It is best to set aside correlation when we assess the
benefits of diversification and focus on dispersion."

Ronald J. Surz and Mitchell Price, "The
Truth About Diversification by the Numbers," Journal of Investing,
Winter 2000, pp. 93-95 (60kb). This paper challenges the
conventional wisdom that a randomly chosen portfolio of 15-20 stocks gives
nearly all the diversification benefit of the market. "Fifteen-stock
portfolios, on average, achieve only 75%-80% of available diversification, not
the 90%-plus typically believed. Even 60-stock portfolios achieve less
than 90% of full diversification." This confirms the prudence of
avoiding individual stocks in favor of highly diversified mutual funds.

For various reasons, many investors find themselves overconcentrated in a
single stock (or very few stocks). Most often, this is the stock of their
employer. What can such a person do to prudently diversify? In
addition to the articles listed here, see the articles on NUA by Bradley and by
Herbers in the "Retirement Investing" section
below.

Thomas J. Boczar, "Stock
Concentration Risk Management After TRA ‘97," Trusts & Estates,
March 1998. This article discusses the some of the implications
of the Taxpayer Relief Act of 1997, as it relates to diversification of
concentrated positions.

Shira J. Boss, "Another
Twist for Exchange Fund Loophole," Forbes.com, March 20 2001.
A very basic discussion of Exchange Funds, which are a "loophole", for the
moment, in the tax law, but only for the very wealthy. Exchange funds
allow you to exchange shares of highly appreciated stock (or even
non-appreciated stocks) into a fund (which also holds the stock of other
contributors) in exchange for shares of the (more diversified) fund. You
hold it for seven years, after which you can cash out your share of the fund's
stock shares. Effectively, this allows you to diversify your portfolio
while delaying realization of capital gains. The Eaton Vance Exchange
fund (CAPEX) may be one of the more interesting options here. Also, see
the Gutner article below.

Roberta Gamba, "Executive Compensation: An
Analytical Approach to Diversification of Concentrated Positions," Journal
of Wealth Management, Fall 2002, pp. 23-29. This article
discusses a computer program which assesses the benefits of diversification
against the tax cost and opportunity cost of doing so.

David M. Stein, Andrew F. Siegel, Premkumar
Narasimhan, and Charles E. Appeadu, "Diversification
in the Presence of Taxes," Journal of Portfolio Management, Fall
2000, pp. 61-71. This excellent paper analyzes the desirability
of liquidating a concentrated stock position with significant unrealized
capital gains. "When the initial asset has substantially more risk
than the benchmark, our results recommend near complete diversification
despite a high initial tax cost." "... greater diversification is needed
with greater initial asset volatility, with longer investment time horizon,
with lower expected return of the initial asset, with higher cost basis, and
with lower risk-free rate. Less diversification is needed when the
investor receives a step-up in basis at the horizon."

David M. Stein, "Death,
Taxes, and Diversification," Investment Advisor, May 2002, pp.
95-99. A good discussion of the tradeoffs which must be
considered around the question of whether or not to diversify a highly
concentrated equity position.

"Prepaid
Variable Forwards: Off the Hot Plate?," XXI Tailored Solutions:
Perspectives for the Professional Investor, Spring 2003.
Discusses a recent IRS ruling that a prepaid variable forward did not
constitute a constructive sale.

"Hedging
Low Basis Stock: Decision Tree," XXI Twenty First Securities, 2002.
A decision tree which helps walk an individual through their options in
dealing with a highly appreciated security. Also, links to various
relevant articles.

With the passage of the Jobs and Growth Tax Relief Reconciliation Act of
2003, certain stock dividends are temporarily (i.e., until the end of 2010) taxed at the same low rate as long-term
capital gains. Some see this as making dividend paying stocks
preferred to non-dividend paying stocks. In fact, nothing can be
further from the truth.
Also see Tax-Managed Investing.

Merton H. Miller, "Do
Dividends Really Matter?," The University of Chicago
Graduate School of Business, Selected Paper #57. This paper validates the idea that whether or not any particular stock pays
dividends is irrelevant to the investor (except that the dividend-paying
stocks are less tax-efficient, which is generally an undesirable feature). Written by a Nobel Prize winner.

John H. Boyd and Ravi Jagannathan, "Ex-Dividend
Price Behavior of Common Stocks," Federal Reserve Bank of Minneapolis
Staff Report Number 173, June 1994. Also in
Review of Financial Studies, 7(4) 1994, pp. 711-741. "In
a variety of tests, marginal price drop [i.e., when a stock goes
ex-dividend] is not significantly different from the dividend amount. Thus,
over the last several decades, one-for-one marginal price drop has been an
excellent (average) rule of thumb."

James A. Campbell and William Beranek, "Stock Price
Behavior on Ex-Dividend Dates," Journal of Finance, December 1955, pp.
425-429. This is the seminal work on ex-dividend stock price
behavior. It showed that there was a virtually immediate drop in the
price of a share of stock upon going "ex-dividend." The amount of the
drop is almost exactly equal to the amount of the dividend (actually, it is
about 90% the price of the dividend). Thus, the fact that a particular
stock paid a dividend doesn't magically (or by any other means) increase the
shareholder's wealth. In fact, due to tax effects, it may actually
decrease the shareholder's wealth.

Harry DeAngelo, Linda DeAngelo, and René
M. Stulz, "Dividend
Policy, Agency Costs, and Earned Equity," Marshall School of Business
Working Paper, June 2004 (101kb). This paper proposes a solution
to the question, "Why do firms pay dividends?" It suggests that
successful firms pay dividends in order to avoid accumulating large amounts of
cash which can't be usefully deployed. Thus it is a means of eliminating
the temptation that might otherwise exist to invest that cash in less
attractive opportunities. We reject this rationale. We believe
that the same effect could be achieved (in a more tax-efficient fashion) simply by using excess cash to buy back
stock.

John R. Graham, Roni Michaely, and Michael Roberts,
"Do
Price Discreteness and Transactions Costs Affect Stock Returns? Ex-day
Evidence During the 1/16ths and Decimal Pricing Eras," Journal of
Finance, December 2003, pp. 2613-2637 (215kb).
Here's the same paper. This paper investigates several
theories proposing to explain the fact that stock prices don't tend to fall
quite as much as they "should" upon going ex-dividend (i.e, "the ex-dividend
pricing anomaly"). It finds that the only such theory which holds up
under testing is the tax hypothesis. This theory posits that "the price
drop is less than the dividend because high personal taxes on dividends
(relative to capital gains) reduce the value of the dividend." This
argument was probably first enumerated by Elton and Gruber in 1970.

Gustavo Grullon, Roni Michaely, Schlomo Benartzi,
and Richard H. Thaler,
"Dividend
Changes Do Not Signal Changes in Future Profitability," Journal of
Business, September 2005. This paper debunks the conventional
wisdom that a company's increase (or decrease) of their dividend conveys some
useful information about the company's expected future profitability. "...
we show that ... dividend changes contain no information about future earnings
changes. We also show that dividend changes are negatively correlated
with future changes in profitability (return on assets)."
Apparently, not only do dividend increases NOT suggest good future
profitability, but rather the opposite!

Dollar Cost Averaging refers to a procedure whereby an equal amount is invested
each period on an ongoing basis. For the purpose of deploying a stream of
cash-flows (e.g., the residue of your take-home pay after subtracting expenses),
this basically just means investing what you have to invest when you have it
available to invest. There are few other good choices in such a situation.
However, for those who are making changes in their portfolios, this might mean
spreading out the change over a period of time rather than making the change all
at once. The below articles address this aspect of Dollar Cost Averaging.
Also see Market Timing.

Peter W. Bacon, Richard E. Williams, and M. Fall
Ainina, "Does
Dollar-Cost Averaging Work for Bonds?," Journal of Financial Planning,
June 1997. This article compares lump-sum investment in bonds vs.
doing it gradually over time. "Does dollar-cost averaging work
for bonds? Based on historical evidence, the major conclusion of our study is
that an investor is better off, in terms of return and risk-adjusted
performance, investing the lump sum immediately."

John G. Greenhut, "Mathematical Illusion: Why
Dollar-Cost Averaging Does Not Work," Journal of Financial Planning,
October 2006, pp. 76-83. This article examines the oft-cited
reason to use dollar-cost averaging — that this
causes the average price per share to be lower than the average share price. "We
found instead that the price variations that would be expected for
fundamentally valued stocks is precisely the pattern that negates the
advantage DCA commonly has been illustrated to hold. .... Whether DCA is
practiced by investors should be based on their psychological makeup (for
example, aversion to regret) and their outlook for stocks, not on an overly
simplistic and misleading representation of how stock prices vary."

Karyl B. Leggio and Donald Lien, "Comparing
Alternative Investment Strategies Using Risk-Adjusted Performance Measures,"
Journal of Financial Planning, January 2003, pp. 82-86. This
article also appeared as "An Empirical Examination of the Effectiveness of
Dollar-Cost Averaging Using Downside Risk Performance Measures," Journal of
Economics and Finance, Summer 2003, pp. 211-223. This paper
compares dollar cost averaging to lump sum investing using three different
measures of risk-adjusted return: Sharpe Ratio, Sortino Ratio, and Upside
Potential Ratio. "...performance metrics that more accurately reflect
investor risk and return such as the Sortino ratio and the UPR also fail to
consistently support DCA as a preferred investing strategy."

Michael S. Rozeff, "Lump-Sum Investing versus
Dollar-Cost Averaging: Those who hesitate, lose," Journal of Portfolio
Management, Winter 1994, pp. 45-50. " ... any investor with
funds to put to work in risky assets should not, as long as the expected risk
premium is positive, hesitate to invest immediately. To spread one's
investment over time simply invites higher standard deviation of return
without an increase in expected return." "...dollar averaging, or
spreading a risky investment out over time, is mean-variance inefficient
compared with a lump-sum investment policy that simply makes a
once-and-for-all lump-sum initial commitment."

This is a large part of the theoretical argument for passive
management and against persistence of mutual fund returns. The developed
world's equity and bond markets are quite efficient. This means that there
are many intelligent rational people trying to maximize their wealth and that
relevant information about securities travels extremely quickly. In other
words, everybody else already knows everything you think you know about a
particular security and they have already taken advantage of that information
(and eliminated any opportunity that may have briefly existed to take advantage
of that information) before you (and I) get a chance to.

"THE
INFLUENCES which determine fluctuations on the Exchange are
innumerable; past, present, and even discounted future events are [all]
reflected in market price ... At a given instant, the market believes in neither
a rise nor a fall of true prices."
— Louis Bachelier, Theory of Speculation, 1900

Eugene F. Fama, "Random Walks in Stock Market Prices,"
Chicago School of Business Selected Paper Series, Paper #16 (102kb).
Also available
here (102kb).
This paper also appeared in Financial
Analysts Journal, September/October 1965, pp. 55-59. Reprinted in
Financial
Analysts Journal, January/February 1995, pp. 75-80. This
paper is a non-technical version of Dr. Fama's doctoral dissertation below. This is
the seminal paper where Dr. Fama coined the term "Efficient Market."
"In an efficient market, competition among the many
intelligent participants leads to a situation where, at any point in time,
actual prices of individual securities already reflect the effects of
information based both on events that have already occurred and on events
which, as of now, the market expects to take place in the future. In other
words, in an efficient market at any point in time the actual price of a
security will be a good estimate of its intrinsic value."

Eugene F. Fama, "The
Behavior of Stock Market Prices,"
Journal of Business, January 1965, pp. 34-105 (8.52mb). This
paper is the technical version of Dr. Fama's doctoral dissertation summarized
above.

Ray Ball, "The Development, Accomplishments and
Limitations of the Theory of Stock Market Efficiency," Managerial Finance,
20 (2,3) 1994, pp. 3-48. A good summary of the research into
stock market efficiency. See
here for an excellent discussion of this paper.

Elroy
Dimson and Massoud Mussavian, "A
brief history of market efficiency," European Financial Management,
March 1998, pp. 91-193 (60kb). An excellent, highly readable
history of the efficient market hypothesis.

Burton G. Malkiel, "The
Efficient Market Hypothesis and its Critics", Journal of Economic
Perspectives, 2003 17(1), pp. 59-82 (523kb). "This survey
examines the attacks on the efficient-market hypothesis and the relationship
between predictability and efficiency. I conclude that our stock
markets are more efficient and less predictable than many recent academic
papers would have us believe."

Burton G. Malkiel, "Reflections
on the Efficient Markets Hypothesis: 30 Years Later", The
Financial Review, February 2005, pp. 1-9 (401kb). "The evidence is
overwhelming that active equity management is, in the words of Ellis (1998), a
'loser’s game.' Switching from security to security accomplishes nothing but
to increase transactions costs and harm performance. Thus, even if markets are
less than fully efficient, indexing is likely to produce higher rates of
return than active portfolio management. Both individual and institutional
investors will be well served to employ indexing ..."

Emerging markets refers to stock markets of economies which are developing
(e.g., China, Russia, Argentina, Mexico, etc.). Investing in emerging
markets is often done with a small portion of one's portfolio in order to get
the diversification benefits offered by this asset class. Also, see
Foreign Investing and
Currency Hedging. Also, see
Frontier Markets.

David G. Booth, "Active
Management's Failure to Deliver in Emerging Markets: A View from the New
Economy," Institute for Fiduciary Education, July 1 2000 (156kb).
This article points out that, compared with passively managed funds, actively
managed funds haven't faired particularly well in emerging markets. This
is contrary to the conventional wisdom, which suggests that less efficient
markets are more amenable to active management.

Asani Sarkar and Kai li, "Should
US Investors Hold Foreign Stocks?," SSRN abstract #319754, January 2002
(47kb). This paper finds that, if short selling is not allowed,
there is no diversification benefit for US investors to diversify in foreign
developed markets. However, diversification into Emerging Markets
remains beneficial under this constraint.

James P. Garland, "A Market Yield Spending Rule
for Endowments and Trusts," Financial Analysts Journal,
July/August 1989, pp. 50-60. This paper proposes a rule for
calculating how much to spend annually from an endowment.

The "Equity Premium" refers to how much stock returns are higher than bond
returns. There are many good reasons to believe that the equity premium in
the future will be much less than the equity premium in the recent past.
It is prudent to have realistic expectations of what stock returns are likely to
be in the future. Therefore, macroscopic estimates thereof are quite
important for investors.

Clifford S. Asness, "Stocks
versus Bonds: Explaining the Equity Risk Premium," Financial Analysts
Journal, March/April 2000, pp. 96-113 (187kb). This paper
presents a model for long term stock dividend yield which suggests that the
difference between stock yields and bond yields is driven by the long-run
difference in volatility between stocks and bonds.

Peter L. Bernstein, "What
Rate of Return Can You Reasonably Expect ... or What Can the Long Run Tell Us
about the Short Run?," Financial Analysts Journal, March/April
1997. "A strange and unexpected conclusion emerges. Stocks are
fundamentally less risky than bonds, not only because their returns have been
consistently higher than those of bonds over the long run but also because
less uncertainty surrounds the long-term return investors can expect on the
basis of past history. Equity investors have at least some notion of what the
long run has provided to owners of equities and at least a few hints as to
whether stocks are high or low relative to their long-run performance.
Investors in the bond market, even with 195 years of history to look back on,
can make no statement at all about a basic return; they can make no judgments
beyond the duration of the particular instrument they happen to be holding at
any given moment."

Elroy Dimson, Paul Marsh, and Mike Staunton, "New
evidence puts risk premium in context," Corporate Finance, March
2003, pp. 8-10 (61kb). "Our work results in a set of forward-looking,
geometric risk premia for the United States, United Kingdom, and for the world
of around 2.5 to 4.0 per cent." "... this corresponds to arithmetic mean
risk premia of around 3.5 to 5.25 per cent."

Amit Goyal and Ivo Welch, "A
Comprehensive Look the the Empirical Performance of Equity Premium Prediction,"
National Bureau of Economic Research Working Paper No w10483, May 2004.
This paper tests whether various empirical means of predicting near-term
equity premiums have been useful in the past. "... we find that, for all
practical purposes, the equity premium has not been predictable, and any
belief about whether the stock market is now too high or too low has to be
based on theoretical prior, not on the empirically [sic] variables we have
explored."

Lacy H. Hunt and David M. Hoisington, "Estimating
the Stock/Bond Risk Premium: An alternative approach," Journal of
Portfolio Management, Winter 2003, pp. 28-34 (317). This
paper's findings are consistent with most others, forecasting an equity premium
significantly below historical norms over the next one to two decades.

Ellen R. McGrattan and Edward C. Prescott, "Average
Debt and Equity Returns: Puzzling?," Federal
Reserve Bank of Minneapolis Research Dept Staff Report 313, January 2003
(232kb).
An interesting look at the "equity premium puzzle" (i.e., why have returns on
equity in the US been so much higher than predicted?). After correcting
for taxes, regulatory constraints, and diversification costs, and focusing on
long-term rather than short-term savings instruments, they find that there
really is no equity premium puzzle.

Estate planning is extremely important for wealthy individuals who wish to
maximize the amount of assets passed on to heirs. In general, it is
important that estate planning be done by an expert — usually a lawyer who
specializes in this area. The below articles discuss investment aspects of
estate planning. Also, see Charitable Giving.

Roccy DeFrancesco, "Gifts
That Keep Giving," Financial Planning, July 2004, pp. 89-92.
A good article which goes into detail about one way to use a Charitable Gift
Annuity in conjunction with a Donor-Advised Fund and a Irrevocable Life
Insurance Trust.

William J. Bernstein, "It's
the Execution, Stupid!," Efficient Frontier, Winter 2004.
This article finds that the best index funds have tended to outperform
"equivalent" ETFs even without considering the costs of bid-ask spreads and
commissions which apply to ETFs, but not index funds.

Edwin J. Elton, Martin J. Gruber, George Comer, and
Kai Li, "Spiders: Where are the Bugs," Journal of Business, July 2002,
pp. 453-472. This paper analyzes the performance of one of the
first Exchange Traded Funds, the S&P 500 SPDR. It finds that this ETF
underperforms similar low cost index mutual funds by 0.18 percentage points
per year. This underperformance is principally due to the fact that
SPDRs (unlike most more modern ETFs) are required to hold dividends received
from their underlying stocks in cash until distribution to shareholders.

Steven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs
offer the World to Investors," A Guide to Exchange-Traded Funds,
Fall 2001, pp. 111-118. "Index based strategies are the most
efficient way to gain international exposure, and should outperform the
average actively managed fund."

These papers explore the intellectual underpinnings for the idea that tilting
a stock portfolio towards small and value stocks will tend to result in higher
long-term expected returns (at the expense of somewhat higher short-term
volatility).

Eugene F. Fama and Kenneth R. French, "The
Cross-Section of Expected Stock Returns," Journal of Finance, Vol
XLVII No 2 June 1992, pp. 427-465 (3.82mb). Also
here. Also
here. Also
here (3.9mb). Also
here. This is the seminal
paper that first provided proof that exposure to market risk, market
capitalization, and book to price ratio almost completely explained
(variations in) the level
of stock returns.

Eugene F. Fama and Kenneth R. French, "Common
risk factors in the returns on stocks and bonds," Journal of Financial
Economics, 33 1993, pp. 3-56 (4.82mb). Also
here. This paper extends the three factor model, which
explains variation in stock returns, to five factors, which also explain
variation in bond returns (the additional factors, only applicable to bonds,
are default risk and term risk (i.e., maturity/duration)). Note that
explanatory power for the two risk factors are only applicable to high-quality
bonds. Lower quality bonds are also affected by the equity factors.

Bala Arshanapalli, T. Daniel Coggin, John Doukas,
and H. David Shea, "The Dimensions of International Equity Style," Journal
of Investing, Spring 1998, pp. 15-30. A look at 1975 to 1996
international returns data confirms that both the value effect and the small
effect exist abroad.

Rolf W. Banz, "The Relationship Between Return
and Market Value of Common Stocks,"
Journal of Financial Economics, 9 (1981), pp. 3-18. "It is
found that smaller firms have had higher risk adjusted returns , on average,
than larger firms. This 'size effect' has been in existence for at least
forty years and is evidence that the capital asset pricing model is
misspecified. The size effect is not linear in the market value; the
main effect occurs for very small firms while there is little difference in
return between average sized and large firms." This paper probably
originated the idea of a size premium.

Sanjoy Basu, "The Relationship Between
Earnings' Yield, Market Value, and Return for NYSE Common Stocks,"
Journal of Financial Economics, 12 (1983), pp. 129-156. "The
results confirm that the common stock of high E/P firms earn, on average,
higher risk-adjusted returns than the common stock of low E/P firms and that
this effect is clearly significant ..." This paper confirmed the
existence of a value premium.

Sanjoy Basu, "Investment Performance of Common Stocks in
Relation to their Price-Earnings Ratios: A Test of the Efficient Market
Hypothesis," Journal of Finance, June 1977, pp. 663-682.
This paper finds that stocks with low price-earnings ratios (i.e., value
stocks) have higher risk-adjusted returns than stocks with high price-earnings
ratios (i.e., growth stocks).

Louis K. C. Chan and Josef Lakonishok, "Value
and Growth Investing: A Review and Update," Financial Analysts
Journal, January/February 2004, pp. 71-86
(85kb). "The evidence suggests that ... value investing generates
superior returns. Common measures of risk do not support the argument
that the return differential is due to the higher riskiness of value stocks.
Instead, behavioral considerations and the agency costs of delegated
investment management lie at the root of the value-growth spread."

James L. Davis, Eugene F. Fama, and Kenneth R. French, "Characteristics,
Covariances, and Average Returns: 1929-1997," February 1999, Center for
Research in Security Prices Working Paper No. 471 (227kb).This paper also appeared in Journal of Finance,
February 2000 Vol 55, pp. 389-406. This paper more than
doubles the sample size of returns analyzed, with the same conclusions as the
original Fama/French paper (the original paper only used data from 1962-1989).

James L. Davis, "Is
There Still Value in the Book-to-Market Ratio?," Dimensional Fund
Advisors, January 2001. Addresses whether BTM ratio has been
superceded by other measures of value, such as Price/Earnings ratio and
others. The bottom line is that BTM remains in several pragmatic ways
the optimal measure of the "value-ness" of a stock.

Elroy Dimson, Stefan Nagel, and Garrett Quigley, "Capturing
the Value Premium in the U.K. 1955-2001," Financial Analysts Journal,
November/December 2003, pp. 35-45. Also
here. "... we find a strong value premium in the UK for the
period 1955-2001. The value premium exists within the small-cap as well
as the large-cap universe." "However, managers attempting to capture the
value premium in the small-cap segment should pay particular attention to
rebalancing-induced portfolio turnover and market illiquidity in small-value
stocks. Compared to the U.S., the U.K. market for small-cap stocks is
relatively illiquid. Trading costs are therefore an even more crucial
determinant of overall performance. This is likely to be the case in
other non-U.S. markets as well." This suggests that it is important to
implement strategies that sacrifice tracking accuracy in favor of reducing
trading needs and lowering trading costs.

Eugene F. Fama and Kenneth R. French, “Value vs. Growth: The International
Evidence,” Journal of Finance, December 1998 Vol
53, pp. 1975-1999 (2.38mb).
This paper also
was SSRN Working Paper 2358 (54kb). This paper examines non-US markets for
the "value premium" and finds it in nearly every other country studied.

Eugene F. Fama and Kenneth R. French, "Size and
Book-to-Market Factors in Earnings and Returns," Journal of Finance,
March 1995, pp. 131-155. "The evidence presented here shows that
size and BE/ME [book to market ratio] are related to profitability."
"Firms with high BE/ME (a low stock price relative to book value) tend to be
persistently distressed." This helps explain why small stocks and value
stocks tend to be have higher returns — because they are
"riskier" than larger and more "growthy" companies.

Sherman Hannah and Peng Chen, "Small
Stocks vs. Large: It's How Long You Hold That Counts,"
Journal of American Association of Individual Investors, July 1999.
This paper concludes that small cap stocks have tended to outperform large cap
stocks in the US for holding periods of greater than 15 years.

Marc R. Reinganum, "Abnormal Returns in Small Firm
Portfolios,"
Financial Analysts Journal, March/April 1981, pp. 52-56.
This paper was among the first to demonstrate the "small" premium.

Barr Rosenberg, Kenneth Reid, and Ronald Lanstein, "Persuasive
Evidence of Market Inefficiency,"
Journal of Portfolio Management, Spring 1985, pp. 9-17.
This paper demonstrated the efficacy of a strategy of investing in value
stocks and shorting growth stocks. In other words, it validated the
existence of a value premium.

"What
Has Worked In Investing," Tweedy, Browne Company,
1992 (289kb). An interesting pamphlet from a small value-oriented
mutual fund company.

Investing internationally with a portion of one's portfolio is often
recommended in order to achieve diversification benefits. Also, see
Emerging Markets and
Currency Hedging.

Scott Aiello and Natalie Chieffe, "International
Index Funds and the Investment Portfolio," Financial Services Review, 8
1999, pp. 27-35. "This study urges caution for those investors
who seek to maximize returns. However, it does suggest that the
diversification one can gain from international index funds is significant and
important." Basically, this study is consistent with the conclusions of Sinquefield (1996) below. Internationally diversifying one's otherwise
domestic equity portfolio yielded a reduction in risk/volatility, but also a
reduction in returns during the period studied.

Marianne Baxter and Urban J. Jermann, "The
International Diversification Puzzle is Worse than you Think,"
American Economic Review, March 1997, pp. 170-180.
Appendix A of
this paper is here. Also NBER Working
paper 5019, February 1995. Also
here. This interesting paper looks at the
degree of international diversification justified when taking into account
an investor's "human capital." This is the present value of a person's future
earnings. It finds that human capital is highly correlated with an
investor's domestic market. When you take that into account, the natural
tendency to overweight one's own country in their portfolio becomes
dramatically amplified. In fact it suggests not only increasing foreign
investment, but increasing it to the
point of actually shorting domestic investments. This paper, therefore, supports
a significant investment overseas for most individual investors.

Marianne Baxter, Urban J. Jermann, and Robert J.
King, "Nontraded
Goods, nontraded factors, and international non-diversification,"
Journal of International Economics, April 1998, pp. 211-229.
This paper's conclusions are consistent with those of the one above.

Eric Brandhorst, "International
Diversification," State Street Global Advisors, July 15 2002.
"International diversification works. Over the past 30 years, portfolios
comprising both U.S. and non-U.S. equities have experienced higher returns and
lower levels of overall risk. Risk reduction was the dominant effect for those
who invested internationally during the past decade."

Stephen E. Christophe and Richard W. McEnally, "U.S.
Multinationals as Vehicles for International Diversification," Journal of
Investing, Winter 2000, pp. 67-75. This paper debunks the
myth that an inexpensive way of getting international exposure is to buy
multinational companies headquartered in the US. The paper finds that
stocks of multinational companies tend to be strongly correlated with the US
stock market, regardless of the location and extent of their foreign
operations.

Philip L. Cooley, Carl M. Hubbard, and Daniel T.
Walz, "Does International Diversification Increase the Sustainable Withdrawal
Rates from Retirement Portfolios?," Journal of Financial Planning,
January 2003, pp. 74-80. Also
here. This study shows that over the period
studied (1970-July 2001), international diversification would have provided almost
no benefit to typical US investors. This is consistent with the
Sinquefield study (1996) below. If the higher costs of foreign mutual
funds were taken into account, the international diversification benefit would
have been worse yet.

Ian Cooper, "An open and shut case for portfolio
diversification," The Financial Times, July 16 2001, p. 4.
"Twenty years or less from now the challenge will be not 'the case for global
investing' but 'why deviate from a globally diversified equity portfolio.'"

Claude B. Erb, Campbell R. Harvey, and Tadas E.
Viskanta, "Do
World Markets Still Serve as a Hedge?," Journal of Investing, Fall
1995, pp. 23-46 (2.1mb). "Do world markets still serve as a
hedge? The answer is affirmative."

Jason T. Greene and Charles W. Hodges, "The
dilution impact of daily fund flows on open-end mutual funds," Journal
of Financial Economics, July 2002, pp. 131-158 (101kb). This
paper measures the effect of a certain kind of day trading that allows some
active traders of mutual funds to earn significant abnormal returns at the
expense of long-term investors in those funds. It concludes that the
effect detracts about 0.5% annually from foreign mutual funds subject to this
effect. Note that the foreign mutual funds Altruist recommends aren't
subject to this effect: those of DFA (their distribution method precludes "day
trading"), Vanguard (they instituted contingent fees in 2003 which
significantly discourage the practice), and certain foreign stock ETFs (they
aren't subject to this effect by their very nature). The paper suggests
that investors may be prudent in avoiding mutual funds which are subject to
manipulation in this manner (i.e., those which haven't taken steps to avoid
this effect).

Herbert G. Grubel, "Internationally Diversified
Portfolios: Welfare Gains and Capital Flows," American Economic Review,
December 1968, pp. 1299-1314. "... recent experience with
foreign investment returns would have given rise to substantial gains in
welfare to wealth holders. If past experiences are considered to be
indicative of future developments, then these data suggest that future
international diversification of portfolios is profitable and that more of it
will take place."

Michael E. Hannah, Joseph P. McCormack, and Grady
Perdue, "International
Diversification with Market Indexes," Academy of Accounting and
Financial Studies Journal, 4(2) 2000, pp. 96-104. "In
theory an investor's portfolio may benefit by being invested in the U.S.
market and another market that is less than perfectly correlated with the U.S.
market. Diversification typically reduces risk significantly at the cost of a
small reduction in return. However, during the decade of the 1990s, U.S.
investors were not rewarded for international diversification. They would have
experienced small reductions in risk coupled with large reductions in return."

Steven L. Heston and K. Geert Rouwenhorst, "Industry
and Country Effects in International Stock Returns," Journal of Portfolio
Management, Spring 1995, pp. 53-58. "... the performance of
international portfolios is largely country-driven, and international
portfolio managers should pay more attention to the geographical composition
than to the industrial composition of their portfolios."

John E. Hunter and T. Daniel Coggin, "An analysis of
the diversification benefit from international equity investment," Journal
of Portfolio Management, Fall 1990, pp. 33-36. "[during the
period studied (1970-1986)], ... international diversification would have
reduced investment risk (defined by variance of return) to about 56% of the
level that could have been achieved using only national diversification.
Hence, while there is a limit on international diversification benefit, the
potential gain is sizable indeed."

Dušan Isakov and Frédéric
Sonney, "On the
relative importance of industrial factors in international stock returns,"
University of Geneva, January 2002 (99kb). This study analyzes
whether international diversification across countries or across industries
gives more diversification benefit. It concludes that, on average, the
country effect continued to dominate during the period studied. However,
the industry effect is increasing in importance and may dominate the country
effect now. It remains to be seen if this is a temporary or permanent
effect.

David S. Laster, "Measuring Gains from International
Equity Diversification: The Bootstrap Approach," Journal of Investing,
Fall 1998, pp. 52-60. This paper concludes that "... raising the
equity allocation to foreign stocks from zero to 20% reduces the probability
of realizing negative returns over a 5 year period by about a third. It also
documents the near certainty of reducing portfolio risk by raising the equity
allocation to foreign stocks above conventional levels." The optimal
allocation seems to be 60/40 domestic/foreign during the period studied
(1970-1996). Such an allocation would have increased risk-adjusted
returns by about 0.65 percentage points annually over that of a purely
domestic equity portfolio during the period studied, through reduction of
risk/volatility (which would also allow an increased allocation to equities,
which would further boost long-term returns).

Steven L. Heston and K. Geert Rouwenhorst, "Does
Industrial Structure Explain the Benefits of International Diversification?,"
Journal of Financial Economics,
August 1994, pp. 3-27. This paper concludes that diversifying
overseas by country makes more sense than diversifying overseas by industry.
"We find that industrial structure explains
very little of the cross-sectional difference in country return volatility,
and that the low correlation between country indices is almost completely due
to country-specific sources of return variation. Diversification across
countries within an industry is a much more effective tool for risk reduction
than industry diversification within a country."

Jean-Francois L'Her, Oumar Sy, and Mohamed Yassine
Tnani, "Country, Industry, and Risk Factor Loadings in Portfolio Management,"
Journal of Portfolio Management, Summer 2002, pp. 70-79.
"... on average, country effects dominated industry effects ...
diversification across countries was more efficient than diversification
across industries." While the study reinforced the supremacy of country
diversification over the nine year period studied, it noted that industry
diversification is becoming an increasingly important factor to consider in
attempting to gain maximal benefits from international diversification.

Jeff Madura and Thomas J. O'Brian, "International
Diversification for the Individual: A Review," Financial Services Review,
1991-1992, pp. 159-175. An excellent review of early work in this
area. "... individual investors can benefit from international
diversification, in effect increasing the efficiency of their portfolios, but
as over time the world market continues to integrate, the benefits may
decline."

Richard O. Michaud, Gary L. Bergstrom, Ronald D.
Frashure, and Brian K. Wolahan, "Twenty years of international equity
investing: still a route to higher returns and lower risks?," Journal of
Portfolio Management, Fall 1996, pp. 9-22 (2.45mb). "... thoughtful
international equity diversification can improve the risk/return
characteristics of investors' portfolios." "Globally diversified
portfolios hold out the very real promise of less risk for the same level of
expected return ... than can be achieved with domestic portfolios." An
outstanding paper.

Patrick Odier and Bruno Solnik, "Lessons for International Asset
Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77.
"Clearly, foreign asset classes provide attractive risk diversification and
profit opportunities." "The risk and return advantages of international
diversification are very large for investors in all the major countries."

Sandeep Patel and Asani Sarkar, "Stock
Market Crises in Developed and Emerging Markets," Financial
Analysts Journal, November/December 1998, pp. 50-61. This
paper finds that, while foreign stocks tend to become less good diversifiers
during severe bear markets (i.e., when you most want their diversification
benefits), the effect only occurs at very short time horizons. For
longer time horizons, their diversification benefit remains intact. "We
confirm the often-held belief that correlations between U.S. and emerging
markets tend to become higher in times of market decline. However, this is
only true for investors who hold stocks for short periods of time---for less
than one year, in the case of Asian stocks. For longer-horizon investors the
correlations remain very small even when markets fall. For these investors,
emerging market [and developed market] stocks continue to provide
important diversification benefits even during periods of significant market
declines."

Mattias Persson, "Long-Term Investing and
International Diversification," SSRN Abstract #302682, March 2002
(110kb).
This paper finds that "investors gain more from internationally diversified
portfolios if the investment horizon is longer, that is, the [optimal] weight
in the international assets are significantly higher for long investment
horizons compared to the one-year horizon."

Judson W. Russell, "The
International Diversification Fallacy of Exchange-Listed Securities,"
Financial Services Review, Volume 7 Number 2 1998, pp. 95-106 (999kb).
This paper assesses the diversification benefit of international equities
traded on US markets (i.e., ADRs, closed-end country funds, and stocks of
multinational corporations). It concludes that "... the U.S.
exchange-listed securities included in this study behave more like the host
exchange than their home exchange. This result suggests that these U.S.
exchange-listed securities, on average, do not perform an international
diversification role for U.S. investors." This finding is consistent
with a strategy of using conventional (open-end) mutual funds in order to
achieve whatever international diversification is desired.

Asani Sarkar and Kai li, "Should
US Investors Hold Foreign Stocks?," Federal Reserve Bank of New
York Current Issues In Economics and Finance, March 2002, pp. 1-6.
Also here (47kb).
This paper finds that, if short selling is not allowed, there is no
diversification benefit for US investors to diversify in foreign developed
markets. However, diversification into Emerging Markets remains
beneficial under this constraint.

Steven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs
offer the World to Investors," A Guide to Exchange-Traded Funds,
Fall 2001, pp. 111-118. "Index based strategies are the most
efficient way to gain international exposure, and should outperform the
average actively managed fund."

Rex A. Sinquefield, "Where are the Gains from International
Diversification?," Financial Analysts Journal, January/February 1996,
pp. 8-14. This paper argues that international value and small stocks
are much better portfolio diversifiers than international large cap (e.g., MSCI EAFE)
during the period studied (1975-1994).

Bruno Solnik, "Why not
diversify internationally rather than domestically?," Financial Analysts
Journal, July/August 1974, pp. 48-54. Reprinted in Financial Analysts
Journal, January/February 1995, pp. 89-94. This
paper is often cited as being among the first to lay out a convincing case for international
diversification of equity portfolios.

Bruno Solnik,
Cyril Boucelle, and Yann Le Fur, "International Market Correlation and
Volatility," Financial Analysts Journal, September/October 1996, pp.
17-34. "Thus, a passive
international diversification strategy of investing 20 percent abroad is still
beneficial from a risk viewpoint. The risk diversification benefits could be
enhanced by ... including emerging markets, which are less correlated with the
U.S. market than developed markets." "The
benefits of international risk reduction are still robust, but the case for
international diversification may be overstated ..."

Bruno
Solnik, "The
View After a Quarter Century," Investment Policy,
May/June 1998, pp. 9-12. A 25 year retrospective after the
1974 paper. "... the risk-diversification benefits of investing
internationally are clear ... overweighting one's home country stocks has a
cost in terms of risk."

Meir Statman and Jonathan Scheid, "Global
Diversification," Journal of Investing Management,
forthcoming (524kb). It suggests that dispersion of returns is a
better measure of the diversification benefit of an asset class than is
correlation. "Dispersion of returns is a better measure of the benefits
of diversification because it accounts for the effects of both correlation and
standard deviation and because it provides an intuitive measure of the
benefits of diversification."

Yesim Tokat, "International
Equity Investing: Long-Term Expectations and Short-Term Departures," Investment Counseling
& Research/ ANALYSIS, May 2004. A good discussion of
issues surrounding investing internationally, including rational reasons to
weight foreign equities somewhat less than theory might suggest. "...
this paper shows that a portfolio diversified into non-U.S. stocks has
typically provided higher returns or lower volatility than a U.S.-only
portfolio over such periods. However, we contend that behavioral and practical
considerations call for a smaller allocation than standard theory may suggest.".

Frontier Markets are countries that aren't developed enough to be considered
"Emerging Markets." Conceptually, whatever
makes Emerging Markets desirable (e.g., low correlation with other stuff) should
apply even moreso with Frontier Markets. At the moment, there is a paucity
of viable investing options in this asset class, the most viable perhaps being
the The iShares MSCI Frontier Markets ETF (FM; E/R: 0.79%) or the Guggenheim
Frontier Markets ETF (FRN; E/R: 0.65%). They are quite new
and somewhat thinly traded at present. Also, see
Emerging Markets.

Amy Schioldager and Heather Apperson, "The
Next Emerging Markets: Pioneering in the frontier," Journal of Indexing,
January/February 2013, pp. 21-26, 60. This paper argues for the benefits of
investing in frontier markets.

Lawrence Speidell and Axel Krohne, "The Case
for Frontier Equity Markets," Journal of Investing,
Fall 2007, pp. 12-22. This paper argues for the benefits of
investing in frontier markets.

Some very wealthy investors invest in Hedge Funds. Hedge Funds are
similar to mutual funds, but they are more risky, less regulated, less liquid,
and dramatically more expensive (not only do they have annual expense ratios of
about 2%, but they typically take 20% or more of all gains as well). We
discourage use of Hedge Funds because they are so very
expensive and because virtually all of them are actively managed.

"If you want to waste your money, it's a good way to do it." "If you want to invest in something where
they steal your money and don't tell you what they're doing, be my guest."
— Dr. Eugene Fama, commenting on the prudence of investing in hedge funds

"If there's a license to steal, it's in the hedge fund arena."
— Dr. Burton Malkiel, commenting on the high costs of hedge funds

"It takes about 35 years of returns to say with any
statistical confidence that stocks have a higher expected return than the
risk-free rate. Think about a hedge fund that has equity-like volatility. If the
manager’s alpha was as large as the market risk premium — which would be huge —
it would also take about 35 years to be confident the manager has any value
added — and that’s before his fees of '2 and 20.' Even if that phenomenal
manager is out there, is he likely to stick around long enough for us to be able
to figure out he wasn’t just lucky?"— Dr. Kenneth French, commenting on the probability of being
able to determine that any particular hedge fund manager had ANY skill

Vikas Agarwal and Narayan Y. Naik, "Multi-Period
Performance Persistence Analysis of Hedge Funds," London Business School
Working Paper, February 2000 (95kb). This study concludes that
there may be some very short term persistence, but it is primarily the poor
performers whose performance appears to persist — persistence among good
performers is dramatically less. This suggests that it may not make
sense to pick a Hedge Fund based on past performance (but it may make sense to
avoid those with particularly poor past performance).

If it doesn't make sense to choose a hedge fund based on past performance, how
would one do it? By minimizing fees? Virtually all hedge funds
have fees ranging from "much too high" to "truly outrageous."

Clifford Asness, Robert Krail, and John Liew, "Do
Hedge Funds Hedge?," Journal of Portfolio Management, Fall 2001,
pp. 6-19 (242kb). Also
here. This excellent paper looks at the risk-adjusted
performance of Hedge Funds. It notes that illiquidity of underlying
investments, among other effects, tends to distort performance numbers.
Specifically, it notes that hedge fund performance tends to lag the
performance of the market. After taking that effect into account, it doesn't
appear that Hedge Funds are very good at "hedging".

Chris Brooks and Harry M. Kat, "The
Statistical Properties of Hedge Funds Index Returns and Their Implications for
Investors," The University of Reading, October 31 2000 (108kb).
"Sharpe Ratios will substantially overestimate the true risk-return
performance of (portfolios containing) hedge funds. Similarly,
mean-variance analysis will over-allocate to hedge funds and overestimate the
attainable benefits from including hedge funds in an investment portfolio."

Bernard Condon, "Hedge
Fund Investing For Dummies," Forbes, May 14 2004.
"Warning to hedge fund investors: You would do better giving your money to a
monkey." You may have to register (for free) to read this article.

Richard M. Ennis and Michael D. Sebastian, "A
Critical Look at the Case for Hedge Funds: Lessons from the Bubble,"
The Journal of Portfolio Management, Summer 2003, pp. 103-112 (235kb).
"Notwithstanding evident market timing skill — at least
during the extraordinary period covered here — the performance of hedge funds
has not been good enough to warrant their inclusion in balanced portfolios.
The high cost of investing in funds of funds contributed to this result.
Many practitioners believe markets are imperfectly efficient, providing astute
investors an opportunity to exploit security mispricing. This may well
be true. One wonders, though, how realistic it is to expect funds of
hedge funds to realize competitive returns for their investors after costs
upward of 5% per year."

William Jahnke, "Hedge
Funds Aren't Beautiful," Journal of Financial Planning, February
2004, pp. 22-25. Also
here. "Hedge funds are a great product for the hedge
fund industry and its support apparatchik ... but are likely, on average, to
produce a negative return contribution relative to a benchmark consisting of
stocks, bonds, and cash." A scathing review of the utility (or lack
thereof) which hedge funds might have for investors.

Alejandro Murguía and Dean T. Umemoto, "An
Alternative Look at Hedge Funds," Journal of Financial Planning,
January 2004, pp. 42-49. Also
here. An outstanding, frank discussion of
hedge funds. "Advisors relying on simple return data and traditional
evaluation measures presented in many hedge fund tear sheets will be
vulnerable to inaccurate conclusions and possibly expose their clients’
investments to an inappropriate amount of risk." "Although
this [hedge fund] manager may seem to be providing excess returns, a
multifactor model that incorporates the dynamic trading strategy of the fund
will indicate that the fund manager is essentially creating these returns by
taking on more risk through the specific trading strategy and not necessarily
through alpha."

"Until further advances are made [in empirical research on what
drives hedge fund returns], advisors may be better served by diversifying
their clients’ portfolios with other un-represented asset classes traded on
major exchanges such as emerging markets or international small cap stocks.
These different asset classes have traditionally been very effective portfolio
diversifiers. Additionally they allow advisors a degree of liquidity and
transparency not currently present in hedge funds."

Larry Swedroe, "Swedroe:
Hedge Funds are Status Symbols," ETF.com, February 5, 2015.
An excellent article that points out some of the problems with Hedge Funds,
noting that they are seen as status symbols among wealthy investors -- a
poor reason to invest in them.

Neil Weinberg and Bernard Cohen, "The
Sleaziest Show On Earth," Forbes, May 24 2004. "Hedge
funds will suck in $100 billion this year from an ever-broader swath of
investors. Pretty good for a business rife with exorbitant fees, phony numbers
and outright thievery." You may have to register (for free) to read this
article.

Andrew B. Weisman and Jerome D. Abernathy, "The
Dangers of Historical Hedge Fund Data." (62kb) This paper
presents a means of describing performance characteristics of Hedge Fund
managers. It also points out two troubling biases which tend to be
present in the data. It calls these biases "Short-Volatility Bias" and
"Illiquidity Bias." These biases tend to cause Hedge Fund performance
data to understate the actual risk/volatility of the funds (and therefore
overstate risk-adjusted performance).

Andrew B. Weisman, "Informationless investing and
hedge fund performance measurement bias: dangerous attractions," Journal of
Portfolio Management, Summer 2002, pp. 80-91. This paper
describes how three phenomena typical of hedge funds each conspire to
overstate the risk-adjusted performance of Hedge Funds (and understate their
correlation with other assets). The result is that most hedge fund
database data is significantly biased, calling into question any conclusions
based on them.

High-yield bonds (a.k.a., "junk bonds") are any bonds issued by companies
which are judged to be poor credit risks (i.e., they may default on their debt).
Because the value of these bonds is so dependent on the likelihood of default
(which in turn is linked with the well-being of the company), they behave both
like conventional investment-grade bonds and like stocks.
If you must invest in High-Yield bonds, we suggest one of the following
selections: the Vanguard
High-Yield Corporate Fund (VWEHX), the TIAA-CREF High-Yield Bond Fund (TCHYX),
the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the PowerShares High
Yield Portfolio (PHB), or the SPDR Barclays High Yield Bond ETF (JNK). Also, see
Bonds.

Low grade bonds realized higher returns than high grade bonds and lower
returns than common stocks, and low grade bonds had lower volatility than
high grade bonds due to their shorter durations (which are a direct result
of the high coupon payments).

There is no relation between the age of low-grade bonds and their
realized returns.

Low grade bonds behave like both bonds and stocks. Despite this
complexity, there is no evidence that low grade bonds are systematically
over- or under-priced.

Bradford Cornell and Kevin Green, "The Investment
Performance of Low-grade Bond Funds," Journal of Finance, March 1991,
pp. 29-48. "When adjusted for risk ... the returns on low-grade
bond funds are not statistically different from the returns on high-grade
bonds."

Martin S. Fridson, "Do High-Yield Bonds Have an
Equity Component?," Financial Management, Summer 1994, pp. 82-84.
"Correlation coefficients consistently show that straight noninvestment-grade
bonds trade nearly as much like stocks as pure debt instruments. The
case for an equity component in high-yield bonds is buttressed by theory.
In effect, a corporate bond is a combination of a pure interest rate
investment and a short position on the issuer's equity. For a highly
rated company, the put is well out of the money. In the case of a
noninvestment-grade bond, however, default is a realistic enough prospect to
enable the equity put to affect the bond's price materially. Empirical
research has confirmed the equity effect."

Robert C. Merton, "On
the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
May 1974, pp. 449-470 (1.58mb). This paper suggests that
corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a
put (i.e., an option to sell the stock) that bondholders issue to the owners
of the company’s stock. As the company's prospects become better, the
stock's price increases, which causes the value of the put to decrease (which
is good for the bondholders who issue the virtual puts), which causes the
value of the bond to increase, which causes the yield on the bond to decrease.
On a separate line of thought, as the company becomes riskier (i.e., more
volatile), the value of the put increases (which is bad for the bondholders
who issue the virtual puts), which causes the value of the bond to decrease,
which causes the yield on the bond to increase. This is how high-yield
bonds get to be high-yield bonds!

There is reason to believe that investing in relatively illiquid investments
will, in the long run and on average, yield higher expected returns than a more
liquid investment of similar risk. If this weren't true, then nobody would
buy them, which would tend to drive down their price, which would tend to
increase the expected returns until it was true. Also, see
Bid-Ask Spreads and
Private Equity.

Viral V. Acharya and Lasse Heje Pedersen, "Asset
Pricing with Liquidity Risk," NYU Stern School Working Paper, July 17 2003
(416kb). Also
here. "It is shown that a security's return depends on its
expected illiquidity and on the covariances of its own return and illiquidity
with market return and market illiquidity."

Yakov Amihud and Haim Mendelson, "The Effects of
Beta, Bid-Ask Spread, Residual Risk, and Size, on Stock Returns," Journal
of Finance, June 1989, pp. 479-486. Another excellent
discussion of this topic.

Yakov Amihud and Haim Mendelson, "Liquidity,
Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance,
September 1991, pp. 1411-1425. This paper confirms the existence
of the illiquidity premium in bonds as well as stocks.

Yakov Amihud and Haim Mendelson, "Liquidity, Asset
Prices and Financial Policy," Financial Analysts Journal,
November/December 1991, pp. 56-66. "When designing an investment
portfolio, a portfolio manager should consider not only the client's risk
aversion, but also its investment horizon. A short horizon calls for
investing in liquid assets, whereas a long investment horizon enables the
investor to earn higher net returns by investing in illiquid assets."

S. Brown, M.A. Milevsky, and T.S. Salisbury, "Asset
Allocation and the Liquidity Premium for Illiquid Annuities," Journal
of Risk & Insurance, Volume 70 Number 3 (345kb).
Here's an
earlier version. "...the required liquidity premium is an
increasing function of the holding period restriction, the subjective return
from the market, and is quite sensitive to the individual's endowed
(preexisting) portfolio."

Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim,
and Wendy Y. Hu, "Liquidity
as an Investing Style", Yale School of Management Working Paper,
August 23, 2012 (322kb). Also here. This paper found that liquidity is a style that is different from size, value/growth or
momentum. Liquidity can potentially be combined with any of the other
traditional styles. Given these findings, one can
combine turnover, size, value and momentum in a model to predict future
returns for individual stocks. They primarily use turnover as a
proxy for liquidity.

Thomas M. Idzorek, James X. Xiong, and Roger G.
Ibbotson, "The
Liquidity Style of Mutual Funds", forthcoming in the Financial
Analysts Journal. More on the illiquidity premium.

Robert Novy-Marx, "On
the Excess Returns to Illiqidity," CRSP Working Paper # 5555, April 8 2004
(85.1kb). This paper argues that the high expected returns
observed on illiquid assets should be expected theoretically, but are not
actually a premium for illiquidity, per se. Instead, illiquidity, like size,
is a proxy for any unobserved risk. Liquidity should therefore have
explanatory power in any asset pricing model that is not perfectly specified,
with low measured liquidity forecasting high expected returns.

Lubos Pastor and Robert F. Stambaugh, "Liquidity
Risk and Expected Stock Returns," Journal of Political Economy,
2003, vol. 111, no. 3, pp. 642-685
(318kb). Also
here and
here. This paper finds that illiquid stocks produced higher
returns than did liquid stocks, adjusted for exposures to the market, sizze,
value, and momentum.

Index weighting refers to how a securities index weights the constituent
securities in its index. Virtually all indexes weight their constituent
securities by market capitalization (notable exception: the Dow Jones Industrial
Average). This makes a certain amount of sense. For example, if you
assume that the market in aggregate is capable of optimizing its allocation,
then a market-cap weighted index makes sense. However, some have pointed
out that the market doesn't price ANYTHING "right" all the time. Some
securities end up being overpriced and some being underpriced at all times.
Unfortunately, the ones that are most overpriced would tend to be the largest
constituents of market-cap-weighted indexes, while the ones that are most
underpriced would tend to be the smallest constituents. Of course, if you
could, you would prefer to concentrate your investments in those securities
which are underpriced, rather than those that are overpriced. This is the
qualitative argument for considering alternative weighting schemes. Note
that equal weighting is perhaps the simplest of the infinitely many possible
alternative (i.e., non-market-cap) weighting schemes.

Robert D. Arnott, Jason C. Hsu, and Philip Moore, "Fundamental
Indexation," Financial Analysts Journal, March/April 2005, pp.
83-99. This was the paper that most spurred interest in this
topic. "In this paper, we examine a series of equity
market indexes weighted by fundamental metrics of size, rather than market
capitalization. We find that these indexes deliver consistent and significant
benefits relative to standard capitalization-weighted market indexes."

André F. Perold, "Fundamentally
Flawed Indexing," Financial Analysts Journal, November/December
2007, pp.
31-37. This paper fairly
definitively debunks the idea that alternative weighting schemes can
systematically outperform without a "value effect." "Holding a stock
in proportion to its capitalization weight does not change the likelihood that
the stock is overvalued or undervalued. The notion that capitalization
weighting imposes an intrinsic drag on performance is, accordingly, false.
Fundamental indexing is a strategy of active security selection through
investing in value stocks. It is a strategy not everyone can follow. Investors
who have no skill in evaluating value tilts and other active strategies should
hold the cap-weighted market portfolio."

William J. Bernstein, "Fundamental
Indexing and the Three-Factor Model," Efficient Frontier, May 2006.
"Fundamental indexing is a promising technique, but its advantage over more
conventional cap-weighted value-oriented schemes, to the extent that it exists
at all, is relatively small." "Even assuming that fundamental
indexation produces returns in excess of its factor exposure, caution should
be used in the practical application of this methodology. Differences in the
expenses, fees, and transactional costs incurred in the design and execution
of real-world portfolios can easily overwhelm the relatively small marginal
benefits of any one value-oriented approach. The prospective shareholder needs
to consider not only the selection paradigm used, but just who is executing
it."

Srikant Dash, "Unveiling
the next generation of Style Indexing," Standard & Poor's, September 20
2005. This white paper performs some comparison analysis on the
Standard & Poor's "True Style" indexes. These indexes are the first
widely available indexes to use a fundamentals-weighting paradigm.

Matthew Hougan, "Quieting
The Noise," Journal of Indexing, September/October 2007, pp.
22-23, 46. This article discusses the (then) unpublished working
paper by Harvard Business School professor André Perold which debunks the idea
that non-cap weighting can be expected to give better results than cap
weighting solely because overvaluing of stocks tends to bias a cap-weighted
portfolio towards being overvalued. The paper quantitatively proves that
this is not true. The qualitative explanation is apparently that even
the largest stocks, by market cap, are just as likely to be undervalued as
they are to be overvalued. So, while weighting by market cap does bias
you towards large market cap companies, those large market cap companies may
either be overvalued or undervalued. So the portfolio is NOT necessarily
biased towards overvalued companies (because some/many of the largest
constituents may, in fact, be undervalued).

Burton G. Malkiel and Kerek Jun, "New Methods
of Creating Indexed Portfolios: Weighing the possibilities of creating
portfolios through Fundamental Indexing," Yale Economic Review,
Summer/Fall 2009, pp. 45-49. "... we found that the measure
of excess returns above those explained by the F-F risk factors is
statistically equal to zero." This paper notes that claimed
outperformance of fundamental indexing is completely explained by its
increased exposure to small and value risk factors, contrary to the claims
of the Arnott/Hsu/Moore paper above. The paper further states a
hypothesis that value investing is likely to be more fruitful during periods
where the dispersion of value measures in the market is greatest.

Marcelle Arak and Stuart Robinson, "I
Bonds versus TIPS: Should individual investors prefer one to the other?,"
Financial Services Review, Volume 15 (2006), pp. 265-280. "Despite
I Bonds’ less attractive real rate, they have several features that add to
their value. They may be redeemed before maturity, at par value plus accrued
interest, eliminating price risk. In addition, taxes may be deferred until
redemption. We estimate the value of these two features, and find that they
are substantial and could potentially offset the lower real rate of I Bonds."

Peng Chen and Matt Terrien, "TIPS
as an Asset Class," Ibbotson Associates, 1999 (104kb). Also
here. This paper also appeared in Journal of Investing, Summer
2001, pp. 73-81. Makes a compelling case for the diversification benefits
of TIPS.

S.P. Kothari and Jay Shanken, "Asset
Allocation with Inflation-Protected Bonds,"
Financial Analysts Journal, January/February 2004, pp. 54-70 (100kb). "... the
measures of [risk-adjusted] portfolio performance ... increase by about 15%
with indexed bonds, as compared to conventional bonds." "These
observations suggest an important role for indexed bonds in a diversified
investment portfolio. The risk-reduction benefits of indexed bonds
reflect fundamental economic relations and are likely to persist in the
future, though the magnitude of those benefits will vary with the inflationary
environment."

Gerald Lucas and Timothy Quek, "A Portfolio Approach
to TIPS," Journal of Fixed Income, December 1998, pp. 75-84.
"We do believe that TIPS can and should be an integral part of most investors
fixed-income portfolios because of their favorable risk/reward profile."

Shlomo Benertzi and Richard H. Thaler, "Myopic
Loss Aversion and the Equity Premium Puzzle,"
Quarterly Journal of Economics, February 1995, pp. 73-92 (1.82mb).
Also here (1.82mb). This paper coined
the term "myopic loss aversion." It refers to the tendency to be
unusually sensitive to short term losses, relative to short term gains.

Uri Gneezy, Arie Kapteyn, and Jan Potters, "Evaluation
Periods and Asset Prices in a Market Experiment," Journal of Finance,
April 2003, pp. 821-838 (181kb). This experiment confirms the earlier work of Thaler/Tversky/Kahneman/Schwartz
below: investors who look at their account balances more often tend to lessen
the riskiness of their portfolios more, which tends to lessen their long-term
returns. Thus, it tends to pay to ignore your periodic investment
account statements.

Richard H. Thaler, Amos Tversky, Daniel Kahneman,
and Alan Schwartz, "The Effect of Myopia and Loss Aversion on Risk Taking: An
Experimental Test," Quarterly Journal of Economics, May 1997, pp.
647-661. This outstanding paper shows that investors who look at
their account balances more often tend to lessen the riskiness of their
portfolios more, which tends to lessen their long-term returns. Thus, it
tends to pay to ignore your periodic investment account statements.

Richard H. Thaler,
published papers. A list (with links to full text!) to
published papers (since 1995) from one of Behavioral Finance's leading
researchers.

Jason Zweig, "Do
You Sabotage Yourself?," Money, May 2001, p. 74. A great look
at the pioneering work of Kahneman and Tversky.

Robert J. Carney and Lise Graham, "A Current Look at
the Debate: Whole Life Insurance Versus Buy Term and Invest the Difference,"
Managerial Finance, Vol 24 Number 12 1998, pp. 25-44. This
paper quantitatively compares a routine of "Buy Term and Invest the
Difference" with buying a whole life policy. "In terms of
terminal wealth at age 65, a 'buy term and invest the difference strategy'
outperforms variable universal life insurance [a type of whole life
policy] in almost every instance."

Jagadeesh Gokhale and Lawrence J. Kotlikoff, "The
Adequacy of Life Insurance," TIAA-CREF Institute research dialogue,
July 2002. This article describes a preferred means of
determining life insurance need and compares it with several "conventional"
approaches.

Market timing refers to an attempt to time investing decisions so as to
invest in assets which are expected to go up in the near term and divest from
assets which are expected to go down in the near term. The most simple implementation may be to shift one's assets
between cash and stocks generically in order to take advantage of anticipated
stock market movements. As you can see from the below studies, attempts at
market timing are only likely to work spuriously, due to occasional good
fortune. We strongly advocate against market timing in all its various
forms. Also, see Dollar Cost Averaging.

"The long, sad history of market timing is clear: Virtually nobody gets it
right even half the time. And the cost of getting it wrong wipes out the
occasional gain of getting it right. So the average investor's experience
with market timing is costly. Remember, every time you decide to get out
of the market (or get in), the investors you buy from and sell to are the best
of the big professionals. (Of course, they're not always right, but how
confident are you that you will be 'more right' more often than they will be?)
What's more, you will incur trading costs or mutual fund sales charges with each
move—and, unless you are managing a tax-sheltered retirement
account, you will have to pay taxes every time you take a profit."
— Charles Ellis, Winning the Loser's Game

"The mathematical expectation of the speculator is
zero. ... The expectation of an operation can be positive or negative only if a
price fluctuation occurs — a priori it is zero." — Louis Bachelier, Theory of Speculation, 1900

William F.
Sharpe, "Likely Gains from Market Timing," Financial Analysts
Journal, March-April 1975, pp. 60-69. "... unless a manager
can predict whether the market will be good or bad each year with considerable
accuracy, (e.g., be right at least seven times out of ten), he probably should
avoid attempts to time the market altogether." Written by a Nobel
Prize winner. Also, see the QuickMBA summary below.

Robert H. Jeffrey, "The folly of stock market
timing: no one can predict the market's ups and downs over a long period, and
the risks of trying outweigh the rewards," Harvard Business Review,
July-August 1984, pp. 102-110. "... no one can
predict the market's ups and downs over a long period, and the risks of trying
outweigh the rewards." "... only a few wrong [market timing]
decisions ... deflate the long-term results produced by market timers to the
point where the timers would be just as well off out of the stock market
entirely." Also, see the update/summary by Rothery
below.

David M. Blanchett, "Is
Buy and Hold Dead? Exploring the Costs of Tactical Reallocation,"
Journal of Financial Planning,
February 2011, pp. 54-61. "The research conducted
for this paper suggests that a long-term static allocation strategy is
likely to produce higher risk-adjusted perfrormance than a tactical asset
allocation [i.e., market timing] approach."

Kirt C. Butler, Dale L. Domian, and Richard R.
Simonds, "International Portfolio Diversification and the Magnitude of the
Market Timer's Penalty," Journal of International Financial Management and
Accounting, 6(3) 1995. This excellent study looks at the
magnitude of the "market timer's penalty." Basically, the market timer
of this study desires to move assets from one country's stock market to
another, presumedly in order to increase risk-adjusted returns. This
study compares a random timer (i.e., a market timer known to have no timing
skill) with a buy-and-hold investor. It finds that the timer's portfolio
is 26.2 percent more risky with the same expected return as that of the buy
and hold investor. Equivalently,
at the same level of risk, the unskilled market timer gives up 20.8% of the
buy-and-hold investor's expected return over the risk-free rate. The
study correctly notes that the potential benefits of market timing are
greatest when correlation between assets is lowest. But this is also
precisely the time when the "market timer's penalty" is the greatest. A
market timer without skill should clearly get out of the market timing business.

Jess H. Chua, Richard S. Woodward, and Eric C. To,
"Potential Gains from Stock Market Timing in Canada," Financial Analysts
Journal, September/October 1987, pp. 50-56. This interesting
paper finds that it is more important to correctly predict bull markets than
bear markets. And buy-and-hold investors effectively have a 100%
accuracy in correctly forecasting bull markets. "If the investor has
only a 50% chance of correctly forecasting bull markets, then he should not
practice market timing at all. His average return will be less than a
buy-and-hold strategy even if he can forecast bear markets perfectly [which is an extremely heroic assumption]."

William G. Droms, "Market Timing as an Investment
Policy," Financial Analysts Journal, January/February 1989, pp. 73-77.
"Gains from market timing over the long run require forecast accuracies that
are likely to be beyond the reach of most managers. More frequent
forecasting increases the potential return available and reduces the level of
accuracy required to outperform the market, but the transaction costs incurred
in more frequent switching reduce the advantage." Note that the study
ignored the largest transaction cost for taxable accounts: short-term capital
gains taxes. If taken into consideration, this would have dramatically
lessened the attractiveness of market timing as a strategy even more.
Note also that prediction becomes much harder as the time period of the
predictions becomes shorter.

Roy D. Henriksson, "Market Timing and Mutual Fund
Performance: An Empirical Investigation," Journal of Business, January
1984, pp. 73-96 (4.55mb). This paper investigated whether mutual funds
exhibited market timing ability. "The empirical results ... do not
support the hypothesis that mutual fund managers are able to follow an
investment strategy that successfully times the return on the market
portfolio."

Burton G. Malkiel, "Models
of Stock Market Predictability," Journal of Financial Research,
Winter 2004, pp. 445-459 (159kb). This study finds that, while
there appears to exist some reversion to the mean behavior, "... there is
no evidence of any systematic inefficiency that would enable investors to earn
excess returns." In other words, market timing models aren't likely
to be fruitful.

Mario Levis and
Manolis Liodakis, "The
Profitability of Style Rotation Strategies in the United Kingdom,"
Journal of Portfolio Management, Fall 1999, pp. 73-86 (131kb).
This paper looks at the feasibility of market timing between growth and value
stocks, and between large and small stocks, in the United Kingdom (i.e., if
you wanted to tactically switch between growth and value, or between large and
small, how accurate would your forecasting need to be in order to beat a buy
and hold strategy?). "Our simulation results suggest that forecasting
the size spread with a 65%-70% accuracy rate may be sufficient to outperform a
long-term small-cap strategy. Beating a long-term value strategy, however, is
markedly more difficult; it requires more than 80% forecasting accuracy."

Austin Pryor, "Timing
isn't as Significant as You Might Expect," Sound Mind Investing,
July 2003. An excellent article pointing out
that even perfect timing doesn't do much better than essentially random timing
(actually, it compares a perfect timing of deposits routine with a dollar cost
averaging routine).

S P Umamaheswar
Rao, "Market Timing and Mutual Fund Performance," American Business Review,
June 2000, pp. 75-79. "The empirical results
do not support the hypothesis that mutual fund managers are able to follow an
investment strategy that successfully times the return on the market
portfolio." Note that if highly paid, highly educated, highly
experienced mutual fund managers can't successfully time the market with the
assistance of large support staffs of brilliant analysts, it seems imprudent
to think that any particular layperson can expect do so.

Robert Sheard, "Market-Timing
Futility," Motley Fool, July 1 1998.
This article supports disciplined periodic investment. It suggests that,
since the long-term return difference between making periodic investments with
perfect timing and with perfectly imperfect timing is small, the important
thing is to be making the periodic investments, not to try to time the
markets. "...for a genuine long-term investor/saver ... it makes
precious little difference when you invest."

John D.
Stowe, "A Market Timing Myth," Journal of Investing, Winter 2000, pp.
55-59. This paper points out that the often cited reason for
avoiding market timing isn't a valid reason. Many articles suggest that,
because the majority of the stock market's gains are confined to a small
number of days or weeks or months, imperfect market timing is likely to
result in missing those runups, with catastrophic results. This article
argues that the same rationale might suggest that the market timer is just as
likely to miss the few worst days, weeks or months, which would tend to
increase returns. Both results would likely be due to luck. Market
timing still seems imprudent, but this isn't the reason why.

Modern Portfolio Theory refers to the idea that each investment ought to be
selected in consideration of how it will interact with other assets in one's
portfolio. Modern Portfolio Theory is the basis for Mean Variance
Optimization.

Harry Markowitz, "Portfolio
Selection," Journal of Finance, March 1952 Vol 7, pp. 77-91
(603kb). Also here. This paper laid the groundwork for Modern Portfolio Theory,
which earned Dr. Markowitz a Nobel Prize. The paper suggests that,
instead of asking the question, "What is a good investment?", you ought to be
asking, "What is a good investment for my portfolio?" It turns
out that the answer is heavily dependent on what else happens to be in your
portfolio. All else being equal, it is more beneficial (from the
standpoint of maximizing your risk-adjusted return) to take on an
investment which is likely to have low correlations with other elements of
your portfolio than to take on an investment which is likely to have high
correlations with other elements of your portfolio. Thus, investment
selection should involve getting maximum diversification benefit (with respect
to the rest of the portfolio) from each
investment.

James S.
Ang, Jess H. Chua, and Anand S. Desai, "Efficient Portfolios versus
Efficient Market," Journal of Financial Research, Fall 1980, pp.
309-319. This paper tested whether constructing "efficient
frontier" portfolios based on past information resulted in superior
performance. The conclusion was that it did not, thus confirming the
weak form of the Efficient Market Hypothesis (note the two different uses of
the word "efficient"). This also proves the imprudence of blindly
using a Mean Variance Optimizer (using historical data as inputs) to construct a portfolio
based on past data.

William J. Bernstein, "The
Appropriate Use of the Mean Variance Optimizer," Efficient Frontier,
January 1998. An excellent discussion of how this tool can be
used and (as is more usual) misused. "Can you use an MVO to help you
shape your portfolio? Yes, but you've got to be very careful. An MVO is like a
chainsaw. Used appropriately, it is a powerful tool for clearing your
backyard. Used inappropriately it will send your local surgeon's kids to
college. Same thing with MVOs. Want to wind up in the financial version of
intensive care? Just throw in some historical (or even plausible) returns and
believe what comes out the other end." "So, what use is the thing? Well,
first and foremost an MVO is a superb teaching tool. Play around with one for
a few hours and you will begin to acquire a grasp of the rather
counterintuitive way in which real portfolios behave." "... you have to
realize that the chances of your allocation, no matter how skillfully chosen,
winding up exactly on the future efficient frontier are zero."

David G. Booth and Eugene F. Fama, "Diversification
Returns and Asset Contributions," Financial Analysts Journal, May/June
1992, pp. 26-32. This paper provides a means for estimating the
compound return contribution of a particular asset to a portfolio containing
it. Basically, it suggests subtracting one half of the asset's
covariance (with the portfolio) from the asset's arithmetic mean return.
The resulting compound return contribution can then be weighted with those of
other assets in the portfolio to obtain the portfolio's compound return.
This takes into account the asset's diversification benefit to the portfolio.

John Rekenthaler, "Strategic
Asset Allocation: Make Love, Not War," Journal of Financial Planning,
September 1999, pp. 32-34. Also
here. This article criticizes blindly
following Mean Variance Optimizer (MVO) outputs during strategic asset
allocation decision-making. We agree with the criticism. MVO is an
interesting tool, but the results are extremely sensitive to the inputs.
The inputs are either guesses about the future or facts about the past.
Either way, we know that the data inputs are extremely imperfect predictors of
the future, which causes decision-making based on them to be significantly
less optimal than may appear to be the case. Dr Eugene Fama on
optimizers: "They're junk. You're wasting your time with an optimizer,
but if you have a lot of time to waste, go ahead."

This refers to an improvement on Modern Portfolio Theory. MPT suggests
using volatility as the measure of an investment's risk. The problem is
that this suggests that abnormally high returns are as much "risk" as abnormally
low returns. Most investors welcome high returns and are only sensitive to
low returns. This inspires the idea of considering risk only to be related
to abnormal low returns and ignoring abnormal high returns. The most
useful such measure of risk would be to consider only abnormal returns below
some customized "minimum acceptable return" to be "risk." This section
contains papers which develop this idea.

Vijay S. Bawa and Eric B. Lindenberg, "Capital
Market Equilibrium in a Mean-Lower Partial Moment Framework," Journal of
Financial Economics, November 1977, pp. 189-200. This paper
derived a version of the Capital Asset Pricing Model which
embraced Lower Partial Moment (a fancy term for downside risk) as the measure
of risk. This model is a more generalized version of the more
traditional CAPM.

W. Van Harlow, "Asset Allocation in a Downside-Risk
Framework," Financial Analysts Journal, September/October 1992, pp.
28-40. An outstanding article on use of downside risk measures
(e.g., downside variance or downside deviation). Downside risk turns out
to be a superior risk measure (i.e., better than standard deviation) in
circumstances where the return distribution is not symmetrical and/or a
"Minimal Acceptable Return" can be defined.

James C.T. Mao, "Survey of Capital Budgeting,"
Journal of Finance, May 1970, pp. 349-360. This paper is
among the earliest to point out the superiority of a downside risk measure to
the standard volatility measures of risk. This paper addresses the
question from the perspective of an executive and notes that the concept of
"risk" held by many financial decision makers is better described by downside
risk measures than by volatility. "Variance is the generally accepted
measure of investment risk in current capital budgeting theory. There are
theoretical reasons for preferring semivariance and the evidence is more
consistent with semi-variance than variance."

David N. Nawrocki, "A
Brief History of Downside Risk Measures," Journal of Investing,
Fall 1999, pp. 9-25 (135kb). Also
Here.
Also
Here. A comprehensive discussion of
downside risk measures. Downside risk turns out to be a superior risk
measure (i.e., better than standard deviation) in circumstances where the
return distribution is not symmetrical and/or a "Minimal Acceptable Return"
can be defined.

A.D. Roy, "Safety First and the Holding of Assets,"
Econometrica, July 1952, pp. 431-450. This may have been
the first paper to suggest the idea of a "minimal acceptable return" as part
of the measurement of risk-adjusted return. Roy suggested
maximizing the ratio "(m-d)/σ", where m is
expected gross return, d is some "disaster level" (a.k.a., minimum
acceptable return) and σ is standard deviation of returns. This
ratio is just the Sharpe Ratio, only using minimum acceptable return instead
of risk-free return in the numerator!

Pete Swisher and Gregory W. Kasten, "Post-Modern
Portfolio Theory," Journal of Financial Planning, September 2005,
pp. 74-85. Also
here. This outstanding article describes a clear improvement
on traditional portfolio theory (a.k.a., Modern Portfolio Theory). The
principle idea is changing the statistics being optimized. In
traditional portfolio theory, the idea is to get the highest return (or
perhaps highest return above a risk-free rate) for some given amount of
volatility. This paper suggests instead trying to get the highest return
(above some Minimal Acceptable Return) for some given amount of volatility,
with the volatility calculated as the deviations below that Minimum Acceptable
Return.

Susan Wheelock, "Risky
Business," Plan Sponsor, September 1995. An excellent,
very readable description of downside risk. All of the performance
measures discussed in the Performance
Evaluation section are risk-adjusted measures. The
Sortino Ratio and the Upside Potential Ratio use downside risk as their risk
measure.

Momentum investing refers to buying stocks that have recently done well and
selling stocks that have recently done poorly. There is evidence that this strategy can be successful in the short term before
transaction fees are considered, but there is also some reason to believe that transaction fees
may tend to "eat up" most, if not
all, of any potential profits. By transaction fees, you need to include
brokerage commissions, bid-ask spreads, and market-impact costs.

Narasimhan Jegadeesh and Sheridan Titman, "Returns
to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,"
Journal of Finance, March 1993, pp. 65-91 (2.8mb). Also
here. This paper
documented a short term (3 to 12 month) momentum effect for stocks. The
paper suggests that it may make sense to buy recent winning stocks and sell
recent losing stocks. Unfortunately, the paper doesn't investigate the
costs associated with implementing such a strategy. For the bad news on
momentum investing, see the Keim and Lesmond/Schill/Zhou papers below.

Clifford S. Asness, Tobias J. Moskowitz, and Lasse
H. Pedersen, "Value
and Momentum Everywhere,"
Journal of Finance, January 2013. Also
here. This paper
finds both that positive value and momentum risk factors exist and that they
are negatively correlated with each other. This suggests that it may
be beneficial to complement value stocks/funds with momentum stocks/funds.

Louis K.C. Chan, Narasimhan Jegadeesh, and Josef Lakonishok, "Momentum Strategies,"
Journal of Finance, Dec 1996, pp. 1681-1713. This paper concludes that,
if transaction costs are ignored, momentum strategies were profitable over a 6
month horizon. But it goes on to add, "A momentum strategy is
trading-intensive, and stocks with high momentum tend to be smaller issues
whose trading costs tend to be relatively high. These implementation
issues will reduce the benefits from pursuing momentum strategies." This statement
was confirmed in a quantitative fashion by the Keim and Lesmond/Schill/Zhou papers below.

Louis K.C. Chan, Narasimhan Jegadeesh, and Josef Lakonishok, "The Profitability of Momentum Strategies," Financial Analysts
Journal, Nov/Dec 1999, pp. 80-90. This paper concludes that,
if transaction costs are ignored, momentum strategies were profitable over a 6
to 12 month horizon. But it goes on to add, "Chasing momentum can
generate high turnover, so much of the potential profit from momentum
strategies may be dissipated by transaction costs." The latter statement
was confirmed in a quantitative fashion by the Keim and Lesmond/Schill/Zhou papers below.

Jon Eggins and Robert J. Hill, "Momentum
and Contrarian Stock-Market Indexes," Journal of Applied Finance,
January 2010, pp. 78-94, also Australian School of Business Research Paper
No. 2008 ECON 07, 2008. This paper makes a case for the
feasibility and desirability of "a new class of investable momentum and
contrarian stock-market indices".

Eugene F. Fama and Kenneth R. French, "Multifactor
Explanations of Asset Pricing Anomalies," Journal of Finance,
Mar 1996, pp. 55-84. Also
here.This paper studied several so-called market anomalies
using the Fama-French three-factor model to see how much of them were
redundant. It found that the only anomaly to survive and not be explained
by the size and value effects was short-term momentum.

Gene Fama, Jr., "The
Big Mo,"
Financial Planning, May 2008, pp. 127-130. The pragmatic
article looks at a practical way that a mutual fund can make momentum work for
it, while avoiding the negative effects. This describes the rationale
behind DFA's momentum screens.

Andrea Frazzini, Ronen Israel, and Tobias J.
Moskowitz, "Trading
Costs of Asset Pricing Anomalies"
Fama-Miller Working Paper, December 5, 2012. After studying
actual implementation data, concludes that transaction costs associated with
attempting to capitalize on the momentum premium (in addition to the size
and value premia) are much more modest than previously thought.
Further concludes that implementing a momentum portfolio seems practical in
the real world. This contradicts the earlier (theoretical) work of the
Keim and Lesmond/Schill/Zhou studies below.

Mark Hulbert, "Value
and Momentum Investing, Together at Last"
New York Times, September 13, 2008. Discusses benefits
from combining a momentum strategy with a value strategy. Such a
combination outperforms either approach individually due to the negative
correlation between the momentum premium and the value premium.

Ronen Israel and Tobias J. Moskowitz, "How
Tax Efficient are Equity Styles?,"
AQR Funds, March 2011. An outstanding look at the feasibility
of tax-managed momentum funds, as compared to the feasibility of
(well-established in the real world) tax-managed value funds. This
paper justifies as prudent and feasible AQR's tax-managed momentum funds: ATMOX, ATSMX, and ATIMX.

Robert Korajczykk and Ronnie Sadka, "Are
Momentum Profits Robust to Trading Cost?," Journal of Finance,
February 2004, pp. 1039-1082. This paper confirms the results of the
Keim and Lesmond/Schill/Zhou studies below. It estimates that momentum
profits would vanish once $5B or so was invested therein.

Donald B. Keim, "The Cost of Trend Chasing and the
Illusion of Momentum Profits," Wharton School working paper, July 29 2003
(1.21mb).
While some studies, such as Jegadeesh/Titman above, suggest that significant
abnormal returns can be gained by following short-term momentum strategies,
few have investigated the trading costs such strategies would require.
This paper studies the actual trading costs incurred by such trading and finds
that the costs exceed the (pre-cost) beneficial effect. In other words,
short-term momentum trading strategies may be successful before costs are
considered, but they aren't sufficiently superior to a more conventional
approach to justify their high transaction costs.

David A. Lesmond, Michael J. Schill, and Chunsheng
Zhou, "The
Illusory Nature of Momentum Profits," Journal of Financial Economics,
February 2004, pp. 349-380 (248kb).
Here's another copy. This paper confirms the results of the
Keim study above. It finds that the stocks which generate the largest
pre-cost momentum returns are the ones with the highest costs. "We
conclude that the magnitude of the abnormal returns associated with these
trading strategies creates an illusion of profit opportunity when, in fact,
none exists."

K. Geert Rouwenhorst, "International
Momentum Strategies,"
Journal of Finance, February 1998, pp. 267-284. This paper
finds the momentum effect in all twelve european countries studied during
the period 1980-1995. This suggests that the momentum effect is NOT a
result of data-mining and is a fundamental feature of stocks.

Rasool Shaik, "Risk-Adjusted
Momentum: A Superior Approach to Momentum Investing,"
Bridgeway Funds, Fall 2011. A discussion of an interesting
"twist" on momentum investing -- rather than investing strictly in stocks
with good recent momentum, it suggests investing in stocks with high amounts
of recent performance per unit of risk (i.e., per unit of volatility).
The Bridgeway Small Cap Momentum Fund (BRSMX) uses an approach like this.

Larry Swedroe, "How
the four stock premiums work,"
CBS MoneyWatch, April 16, 2012. A good layperson's
discussion of the size of the Market, Size, Value, and Momentum premiums and
their interaction with each other.

Mortgage refinancing is largely an investing issue. Homeowners are
always wondering whether they should refinance, whether they should take
additional cash out of their homes, what term of mortgage should they get, what
points should they pay, etc.

Gene Amromin, Jennifer Huang, and Clemens Sialm, "The
tradeoff between mortgage prepayments and tax-deferred retirement savings," Journal of
Public Economics,
91 2007, pp. 2014-2040. This paper addresses the related
question of whether it is beneficial to pay off a mortgage early. It
suggests that, in general, it may be more beneficial to increase
contributions to tax-deductible retirement plans (e.g., 401(k), 403(b), 457,
deductible traditional IRA, etc.) rather than using that money to pre-pay
mortgages.

Vance P. Lesseig and John G. Fulmer, Jr., "Including
a Decreased Loan Life in the Mortgage Decision," Journal of
Financial Planning, December 2003, pp. 66-71. This excellent
paper thoroughly discusses the tradeoffs between a 15-year and a 30-year
mortgage. It also discusses the issue of how much to pay in points.

Fees should be one of the primary considerations when selecting a mutual
fund. Much of investing requires dealing with uncertainties. Fees,
however, are one of the few important factors that you have complete control
over. It is almost always prudent to minimize fees, unless you have a
compelling reason not to.

"Beware of small expenses; a small leak will sink a great ship."
— Benjamin Franklin

John M.R. Chalmers, Roger M. Edelen, and Gregory B.
Kadlec, "Fund
Returns and Trading Expenses: Evidence on the Value of Active Management,"
Working Paper, October 15 2001. "We find a strong negative
relation between fund returns and trading expenses. In fact, we cannot
reject the hypothesis that every dollar spend on trading expenses results in a
dollar reduction in fund value." "In this paper we reject the hypothesis
that active fund management enhances performance. We attribute our
strong results to our more direct measure of mutual fund trading expenses.
... we find a strong negative relation between fund returns and trading
expenses, while we find no relation between fund returns and turnover."

Stephen P. Ferris and Don M. Chance, "The Effect of
12b-1 Plans on Mutual Fund Expense Ratios: A Note," Journal of Finance,
September 1987, pp. 1077-1082. This paper notes that 12b-1 plan
fees definitely increase current expenses and therefore decrease current
returns. It remains to be seen if they subsequently tend to allow mutual
funds to realize economies of scale which then result in a net decrease in
fees. This paper is consistent with a strategy of avoiding funds that
have 12b-1 fees.

Irving L. Gartenberg v.
Merrill Lynch Asset Management (694 F.2d 923 (2d Cir. 1982), cert denied ,
461 U.S. 906(1983). Would you like to sue your mutual fund
managers for charging you outrageous fees? This case established what
you need to do to be successful (or at least, to avoid having your case
dismissed): "To be guilty of a violation of § 36(b), therefore, the
adviser-manager must charge a fee that is so disproportionately large that it
bears no reasonable relationship to the services rendered and could not have
been the product of arm's-length bargaining."

Eric E. Haas, "Mutual
Fund Expense Ratios: How High is Too High?," Journal of Financial
Planning, September 2004, pp. 54-63 (135kb). Also
here. This paper
quantitatively answers the question, "How high can a mutual fund's expense
ratio be before it detracts from, rather than adds to, the expected risk-adjusted
performance of a portfolio?" This question is central to building a
portfolio of mutual funds. If the expense ratio of a prospective
additional fund is too high, it will have a negative impact on your
portfolio's performance. This paper won the 2004 Journal of Financial
Planning Call for Papers Competition.

Jason Karceski, Miles Livingston, and Edward S. O'Neal, "Portfolio
Transactions Costs at U.S. Equity Mutual Funds," Zero Alpha Group
Working Paper, November 15 2004 (68.2kb).
Here's an
article about this study. This paper
quantitatively investigates the extent of "implicit" expenses incurred by
mutual funds. These expenses, not reflected in a fund's expense ratio,
can be as high, or higher, than the "explicit" expense reflected by the
expense ratio.

Tom Lauricella, "This
is news? Fund fees are too high, study says," SFGate.com, August 27
2001. This article discusses a study which shows that mutual
funds charge their retail customers higher fees than they charge their
institutional customers for the same services.

Miles Livingston and Edward S. O'Neal, "Mutual Fund
Brokerage Commissions," Journal of Financial Research, Summer 1996, pp.
273-292. "... investors can on average reduce exposure to high
commissions by concentrating on larger, low expense ratio mutual funds."
"... some mutual fund managers may be charging investors high management fees
even though investors finance much of the research services through soft
dollar commissions." This paper's conclusions reinforce the strategy of
buying passively managed mutual funds with low expense ratios.

John Markese, "How
Much Are You Really Paying For Your Mutual Funds?," AAII Journal,
February 1999. "Loads and expenses decrease your mutual fund
return dollar-for-dollar. Looking forward—the best direction in which to look
to make judgments—loads and expenses are predictable; returns are not. Loads
are sales commissions paid to sales personnel and have only a negative impact
on fund performance. Fund expenses that are significantly higher than the
average for a category are difficult for fund managers to overcome."

Robert W. McLeod and D.K. Malhotra, "A
Re-Examination of the Effect of 12b-1 plans on Mutual Fund Expense Ratios,"
Journal of Financial Research, Summer 1994, pp. 231-240. "Our
study confirms ... that 12b-1 charges are a deadweight cost to shareholders."
"... the introduction of 12b-1 plans has not resulted in the benefits
suggested by proponents ..." The conclusions of this paper are
consistent with a strategy of avoiding mutual funds with 12b-1 fees.

Ross M. Miller, "Measuring
the True Cost of Active Management by Mutual Funds," SUNY Albany,
June 2005 (92.4kb). This
interesting paper derives a method for allocating fund expenses between active
and passive management and constructs a simple formula for finding the cost of
active management. Computing this “active expense ratio” requires only a
fund’s published expense ratio, its R-squared relative to a benchmark index,
and the expense ratio for a competitive fund that tracks that index. At the
end of 2004, the mean active expense ratio for the large-cap equity mutual
funds tracked by Morningstar was 7%, over six times their published expense
ratio of 1.15%. More broadly, funds in the Morningstar universe had a
mean active expense ratio of 5.2%, while the largest funds averaged a percent
or two less.

S P Umamaheswar Rao, "Economic Impact of
Distribution Fees on Mutual Funds," American Business Review, January
2001, pp. 1-5. "The main conclusion is that the 12b-1 plan did
not offer economic value to shareholders."

John D. Rea, Brian K. Reid, and Travis Lee, "Mutual
Fund Costs, 1980-1998," Investment Company Institute Perspective,
September 1999, pp. 1-12 (452kb). Note that the ICI's studies
tend to be flawed in that they rely on sales-weighted costs of funds in their
analyses of fund costs. Their conclusion that fund costs are decreasing
isn't valid based on that information — their conclusion should be that
consumers' sensitivity to costs is increasing, but costs are also increasing
(which the ICI studies tend not to measure).

Paul F. Roye, Director of US Securities and Exchange
Commission Division of Investment Management,
Memorandum on Mutual Fund Fees, June 9 2003 (1.25mb). This
memo expounds on the SEC's position on various issues related to Mutual Fund
Fees. It was generated in response to
this letter.

Stefan Sharkansky, "Mutual
Fund Costs: Risk Without Reward," PersonalFund.com, July 2002
(189kb). "... what, if anything, can an investor do to improve
the odds of selecting a winning fund, and to reduce the odds of getting stuck
with a losing fund? The answer is surprisingly simple: invest only in
low-cost funds and avoid high-cost funds."

Nicolaj Siggelkow, "Caught
between two principals,"
Wharton School, May 2004 (137kb).
Here's the link
to the actual paper. This paper finds that mutual funds tend,
through their actions, to favor the interests of the fund company over the
interests of fund shareholders.

Lori Walsh, "The Costs and Benefits to Fund
Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses, and
Returns," U.S. Securities and Exchange Commission, April 26 2004
(785kb).
"The paper finds that while funds with 12b-1 plans do, in fact, grow
faster than funds without them, shareholders are not obtaining benefits in the
form of lower average expenses or lower flow volatility." "These
results highlight the significance of the conflict of interest that 12b-1
plans create. Fund advisers use shareholder money to pay for asset growth from
which the adviser is the primary beneficiary through the collection of higher
fees."

Greg Wolper, "Girl
Scout Cookies, the Mutual Fund Way," Morningstar.com, January 27 2004.
A great tongue-in-cheek article about how girl scout cookie sales might work
if they were sold like mutual funds. You may have to register (for free)
to read this article.

"Mutual
Fund Fees and Expenses", Investment Company Institute. Links
to several studies on this topic. Note that the ICI's studies tend to be
flawed in that they rely on sales-weighted costs of funds in their analyses of
fund costs. Their conclusion that fund costs are decreasing isn't valid
based on that information — their conclusion should be that consumers'
sensitivity to costs is increasing, but costs are also increasing (which the ICI studies tend not to measure).

"Mutual
Fund Fees and Expenses," U.S. Securities and Exchange Commission, October
19 2000. A brief tutorial on the major types of fees associated
with mutual funds.

"Funds
With Low Expense Ratios Outperforming Their More Expensive Peers Over Long
Term, Says S&P," Standard & Poor's, June 11 2003. An
excellent short press release which makes the case for minimizing a mutual
fund's expense ratio, all else being the same. Interestingly, you'll
note from studying the data that the difference in expense ratios has a strong
correlation with the difference in returns (implying that, for every dollar of
additional expenses paid, you lose a dollar in returns).

Mutual Fund Persistence refers to the question of whether past performance of
a mutual fund has any positive correlation with future performance. The
lack of persistence in mutual funds (and pension funds, etc.)
is a large part of the empirical argument for passive management.

The
root of this issue is whether it is possible for
ANY actively-managed mutual fund to consistently achieve superior
risk-adjusted returns. This is
an important question. If the answer is no, then it implies that actively
managed funds should be avoided (because they tend to be more expensive). If the answer is yes, then it inspires a
separate, but equally important, question of whether it is possible to identify
the few funds which will consistently outperform in advance. We believe
that, while it is possible for an actively managed fund to occasionally achieve
superior returns through good luck, it is impossible to identify those lucky
mutual fund managers in advance. The majority of well-done studies tend to
support a lack of persistence for all but the worst performing equity mutual funds.

Mark M. Carhart, "On Persistence in Mutual Fund Performance,"
Journal of Finance, March 1997, pp. 57-82 (3.1mb). This may be the best and
most authoritative study of persistence. The study concludes that there
is virtually no persistence, except for the worst performing mutual funds
(which is explainable either by their having high fees, poor
strategies, and/or tax-loss harvesting by investors).

Stephen J. Brown and William N. Goetzmann,
"Performance Persistence," Journal of Finance, June 1995, pp. 679-698
(2.1mb).
This paper concludes that some persistence does seem to exist among mutual
funds, but it is
mostly due to poor performers (i.e., poor performance persists, but good
performance doesn't). This paper's conclusions confirm the prudence of a
passive strategy of investing in low cost index mutual funds.

A negative relationship exists between a fund's style consistency and
portfolio turnover.

A positive relationship exists between a fund's style consistency and the
future actual and relative returns it produces.

A positive relationship exists between the consistency of a portfolio's
investment style and the persistence of its performance over time.

Jeffrey A. Busse, Amit Goyal, and Sunil Wahal,, "Performance
Persistence in Institutional Investment Management ," Journal of
Finance, April 2010, pp. 765-790. An older version is also
here.
"... there is only modest evidence of persistence in three-factor
models and little to none in four-factor models." This paper
largely confirmed the results of the older Carhart paper above, using
similar methodology.

James L. Davis, "Mutual Fund Performance and Manager
Style," Financial Analysts Journal, January/February 2001, pp. 19-27.
"The results of this study are not good news for investors
who purchase actively managed mutual funds."

F. Larry Detzel and Robert A. Weigand, "Explaining Persistence in Mutual
Fund Performance," Financial Services Review, 1998 Vol 7 issue 1, pp.
45-55 (990kb). This paper found that there was virtually no persistence
that could not be explained by market risk, expense ratios, market
capitalization, and book to market ratio.

Miranda Lam Detzler, "The
Value of Mutual Fund Rankings to the Individual Investor," Journal
of Business and Economic Studies, 2002 Vol 8 issue 2, pp.
48-72 (97kb). "This paper investigates whether an investment
strategy based on mutual fund rankings by the popular press can earn abnormal
returns ... The ranked funds have higher excess returns relative to peer funds
during the pre-ranking period, but have similar excess returns as their peers
in the post-ranking period. These results do not support the short-term
persistent performance hypothesis. The ranked funds also have higher risk,
measured by standard deviations, in both the pre- and post-ranking periods."

William G. Droms and David A. Walker, "Performance Persistence of
International Mutual Funds," Global Finance Journal, 12 2001, pp.
237-248. This paper finds that, consistent with studies of
domestic funds, international funds also have no unexplainable persistence
beyond a one-year momentum effect.

Ronald N. Kahn and Andrew Rudd, "Does
Historical Performance Predict Future Performance?," BARRA Newsletter,
Spring 1995 (735kb). This paper also appeared in Financial Analysts Journal,
November/December 1995, pp. 43-52. This paper finds no
persistence in stock funds, but some persistence in bond funds. However,
the persistence in bond funds still points to a passive strategy because the
small benefit of being able to pick winning (active) bond funds is more than cancelled
out by the disadvantage of higher expense ratios associated therewith.

Burton G. Malkiel, "Returns from Investing in Equity Mutual Funds 1971 to
1991," Journal of Finance, Vol L No. 2 June 1995, pp. 549-572.
Dr. Malkiel finds persistence in the 70s, but not in the 80s. He
concludes that if persistence exists, it is not robust and that passive
management appears to be the best choice.

Shawn Phelps and Larry Detzel, "The nonpersistence
of mutual fund performance," Quarterly Journal of Business and Economics,
Spring 1997, pp. 55-69. "The lack of reliable positive
persistence indicates that investors should not select mutual funds on the
basis of past performance."

Gary E. Porter and Jack W. Trifts, "The Performance Persistence of
Experienced Mutual Fund Managers," Financial Services Review, 1998 Vol
7 issue 1, pp. 57-68 (1.04mb). The study finds that having an experienced
manager at the helm of a fund doesn't help its performance persistence. "While superior performance is not
persistent, there is evidence that inferior performance does persist."

Garrett Quigley and Rex A. Sinquefield, "The
Performance of UK Equity Unit Trusts," Institute for Fiduciary Education,
October 1 1999 (198kb). This paper also appeared in Journal of Asset
Management, February 2000. This provides a look at mutual fund
persistence in the United Kingdom. "Does performance persist? Yes,
but only poor performance."

The question of whether to invest in actively or passively managed mutual
funds is an important one. Both theoretical arguments (see
Efficient Market Hypothesis) and empirical
evidence (see Mutual Fund Persistence) suggests that
passive management (e.g., investing in index mutual funds) is usually prudent.

William F. Sharpe, "The
Arithmetic of Active Management," Financial Analysts Journal,
January/February 1991, pp. 7-9. "If 'active' and 'passive'
management styles are defined in sensible ways, it must be the case that (1)
before costs, the return on the average actively managed dollar will equal the
return on the average passively managed dollar and (2) after costs, the return
on the average actively managed dollar will be less than the return on the
average passively managed dollar. These assertions will hold for any
time period." This brief, lucidly written article is perhaps the simplest and most
persuasive theoretical case ever made for passive management. Written by a Nobel
Prize winner.

Anna Bernasek, "The
Man Your Fund Manager Hates," Fortune, December 1999.
An interview with Burton Malkiel, author of
A Random Walk Down Wall Street: The Best Investment Advice for the New Century.

John C. Bogle, "Selecting Equity Mutual Funds: Why
is it virtually impossible to pick the winners, yet so easy to pick a winner?
And what should you do about it in the 1990s?," Journal of Portfolio
Management, Winter 1992, pp. 94-100. "Picking the
winning fund is virtually impossible, because reliance on past performance is
of no apparent help." "Picking a winning fund is made easy by
selecting a passive all-market index fund, or perhaps by engaging in thorough
research and careful analysis." "... intelligent investors simply cannot
disregard the heavy burden of costs endemic to most actively managed funds,
and clearly should consider index funds for at least a core portion of their
equity holdings."

David G. Booth, "Index
and Enhanced Index Funds," Dimensional Fund Advisors, April 2001. "In summary, logic and empirical evidence overwhelmingly favor an investment
approach based on index funds. The returns are higher and the fees are lower.
The returns of an asset class are assured. The discipline keeps the portfolio
fully invested, thereby avoiding the adverse timing pitfall inherent in
investment committees and active managers."

Eric Brandhorst, "Problems
with Manager Universe Data," State Street
Global Advisors, November 22 2002. This article debunks the often
repeated notion that active managers tend to beat passively managed portfolios
in small and international asset classes. "Even the two asset classes
(international equity and U.S. small cap) that are often held up as examples
of arenas where active managers can consistently add value lose their active
management luster when appropriate adjustments are made to the median manager
data."

Richard M. Ennis and Michael D. Sebastian, "The
Small -Cap Alpha Myth," Journal of Portfolio
Management,
Spring 2002, pp. 11-16 (180kb). This paper debunks the popular perception
that it is beneficial to use active management in small-cap stocks.

Eugene F. Fama and Kenneth R. French, "Luck
versus Skill in the Cross Section of Mutual Fund Returns," Journal of
Finance,
October 2010, pp. 1915-1947. This paper uses an approach similar to
that used in the Murphy paper below, only using more real-world data.
This paper takes real data of mutual fund performance (i.e., which shows a
range of estimated alphas) and deliberately adjusts each fund's performance
data set so that its alpha is zero (i.e., its estimated alpha is subtracted
from each data point). Thus, each synthetic fund now has a known alpha
exactly equal to zero. This data base of synthetic zero alpha funds
was then used to generate 10,000 monthly returns using a bootstrap sampling
approach (with replacement). These monthly returns yielded an example
of what might be expected in real life if it were true that the true alphas
of each fund were, in fact, exactly equal to zero. The paper found
that the distribution of realized alphas from the simulation (i.e., where it
was known that the true alpha was zero -- that any resulting apparent alpha
was merely due to good luck) was similar to that found for actual funds.
In fact, if anything, the distribution of alpha estimates for real funds
showed that the actual alpha of real funds was probably negative, but no
better than approximately zero. Thus, good alpha estimates for real
funds were consistent with what would be expected through luck alone (i.e.,
suggesting that good results of actively managed funds are due to good luck
and not skill).

Eugene F. Fama and Kenneth R. French, "Luck
versus Skill in Mutual Fund Performance," Fama/French Forum,
November 30, 2009. This is a slightly less technical
description of the above Fama/French paper. The paper uses a
simulation to show that the actual alphas of actively managed funds are no
better than, and probably worse than, those expected purely through good
luck alone (i.e., worse than they would be through simulations with alphas
pre-programmed to be exactly zero). This suggests that apparently good
performance of actively managed funds is generally consistent with what
would be expected through luck alone (i.e., good performance should
generally be attributed to good luck and not to skill). However, this
is not evident from merely evaluating an active manager's performance, even
if it is adjusted for risk (e.g., a calculated "alpha").

Rich Fortin and Stuart Michelson, "Indexing
vs. Active Mutual Fund Management," Journal of Financial Planning,
September 2002, pp. 82-94. Also
here. This paper supports the superiority of
passive management. Unfortunately, they used a database which is subject
to survivorship bias (which they readily admit, but seem to ignore when
generating their conclusions). Therefore, their observation that active
management appears to be beneficial for small and international stocks cannot
be considered conclusive.

Philip Halpern, Nancy Calkins, and Tom Ruggels,
"Does the Emperor wear clothes or not? The final word (or almost) on the
parable of investment management," Financial Analysts Journal,
July/August 1996, pp. 9-15. This paper uses the children's tale of "The
Emperor's New Clothes" to expose how investors may be fooled into
believing that active management is beneficial (just as the Emperor was fooled
into believing that his tailors had made him new clothes when he was, in fact,
naked). "The questions are: 1. Have plan sponsors, like the Emperor,
been tricked by the tailors of the investment management business into
believing that active management adds value? 2. Can money managers be
identified and hired that will consistently beat the market? Most studies seem
to suggest that the answer to the first question is yes, and the answer to the
2nd question is no."

Burton G. Malkiel,
"Reflections
on the Efficient Market Hypothesis: 30 Years Later," The Financial
Review,
February 2005, pp. 1-9. "The evidence is overwhelming that
active equity management is, in the words of Ellis (1998), a 'loser’s game.'
Switching from security to security accomplishes nothing but to increase
transactions costs and harm performance. Thus, even if markets are less than
fully efficient, indexing is likely to produce higher rates of return than
active portfolio management. Both individual and institutional investors will
be well served to employ indexing"

Thomas P. McGuigan,
"The
Difficulty of Selecting Superior Mutual Fund Performance," The
Journal of Financial Planning,
February 2006, pp. 50-56. An interesting study. They
conclude that the overwhelming majority of actively managed funds underperform
passive alternatives. While they concede that there have been a very
small minority of actively managed funds which have consistently outperformed
passive alternatives, it is "difficult" to identify them in advance.

Ross M. Miller, "Measuring
the True Cost of Active Management by Mutual Funds," SUNY Albany,
June 2005 (150kb). This
interesting paper derives a method for allocating fund expenses between active
and passive management and constructs a simple formula for finding the cost of
active management. Computing this “active expense ratio” requires only a
fund’s published expense ratio, its R-squared relative to a benchmark index,
and the expense ratio for a competitive fund that tracks that index. At the
end of 2004, the mean active expense ratio for the large-cap equity mutual
funds tracked by Morningstar was 7%, over six times their published expense
ratio of 1.15%. More broadly, funds in the Morningstar universe had a
mean active expense ratio of 5.2%, while the largest funds averaged a percent
or two less.

Rex A. Sinquefield, "Active
vs. Passive Management," Dimensional Fund Advisors, October 1995.
A speech given during a debate on the merits of active vs. passive management.

Steven R. Thorley, "The
Inefficient Markets Argument for Passive Investing," Brigham Young
University, September 1999. This paper argues that passive
investing is indicated even if you assume that markets are inefficient and
that stock-picking can successfully "beat the market."

Russ Wermers, "Mutual
Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style,
Transaction Costs, and Expenses," Journal of Finance, Vol LV No. 4
August 2000, pp. 1655-1695 (182kb). This paper concludes that the stocks held by active mutual funds exceeded the
market index by 1.3% per year, but that those same funds underperform the same
market index by 1% per year after fund costs and "cash-drag" are accounted
for. The bottom line is that this paper's data suggests that it is
beneficial to invest in a market index fund (NOT an actively managed fund) as
long as that fund's costs and "cash drag" are less than 1% per year.
This hurdle is easily cleared by, for example, the Vanguard Total Stock Market
Index Fund (VTSMX), whose costs and cash drag appear to be less than 0.2% per
year. In other words, the average active equity fund investment dollar
could have annual returns of about 0.8 percentage points higher simply by
investing in a good market index fund.

This section addresses how a corporation should invest its pension assets.
In practice, the average pension plan is funded somewhere in the vicinity of a
60/40 stock/bond mix. Note that what is appropriate for a corporation is not necessarily also
appropriate for individuals trying to fund their own retirements.

Fisher Black, "The Tax Consequences of Long-Run
Pension Policy," Financial Analysts Journal, July-August 1980, pp.
21-28. A similar paper is available
here. This paper suggests that pension funds ought to be
invested 100% in bonds. The rationale is one of tax arbitrage:
First, the company fully funds its pension plan with 100 bonds, of the
approximate same credit quality as those of the company itself. If it
needs to borrow in order to get the funds to do so, it should borrow by
issuing bonds itself. The benefit here is that the bonds in the pension
fund earn pre-tax returns (because pension fund profits are not taxed).
But the company can deduct the interest payments it makes on bonds it issues.
So the company makes pre-tax returns on the bonds in its pension fund and pays
post-tax interest rates on the borrowed money. If the pension bonds and
the bonds the company issued have similar duration and credit quality (which
you should try to ensure), that means that the company has a guaranteed profit
of the amount of taxes saved through the interest deduction. Guaranteed
profit is good.

But won't investors be concerned about the company's increased debt level?
They shouldn't be. If they look at the combined balance sheet of the the
company and its pension fund (which they should), they would notice that the
company's valuation hadn't changed. If anything, the company's balance
sheet should look more attractive to investors since the risk of underfunding
the pension plan has been removed. Less risk of need for future
additional pension funding is good.

Of course, another benefit is that the pension plan participants would be well
served by this policy, as would the Pension Benefit Guaranty Corporation.

Richard A. Ippolito, "The Role of Risk in a
Tax-Arbitrage Pension Portfolio," Financial Analysts
Journal, January-February 1990, pp. 24-32. "It is optimal for
firms to invest pension assets primarily in equities." This paper argues
that stocks exclusively should be used to fund pensions.

Irwin Tepper, "Taxation and Corporate Pension
Policy," Journal of Finance, March 1981, pp. 1-13. This
paper suggests that corporations should fully fund their pension plans and
should fund them 100% with bonds. This paper is largely consistent with
the Black paper above.

"Pension
Plan Issues: Investment Framework," The Vanguard Group, 2006.
An even-handed discussion of the pros and cons of the two major strategies for
pension investment: total return and asset-liability matching.

Is it possible to evaluate the relative "goodness" of an investment manager?
If so, how should one go about it? What should be avoided? The
concern here is to avoid evaluation strategies which might tend to cause one to embrace
unskilled managers and/or to exclude skilled managers. Also, see the section on
Risk Measures and
Performance Measurement.

"Good clients will, if they decide to use active managers, insist that
their managers adhere to the discipline of following through on agreed-upon
investment policy. In other words, the investor client will be equally justified
and reasonable to terminate a manager for out-of-control results above
the market as for out-of-control results below the market. Staying with a
manager who is not conforming his or her portfolio performance [to
agreed-upon investment policy] or to prior promises is speculation— and ultimately will be 'punished.'

But staying with the competent investment manager who is conforming to his or
her own promises — particularly when out of
phase with the current market environment —
shows real 'client prudence' in investing and ultimately will be well rewarded."
— Charles Ellis, Winning the Loser's Game

Elroy Dimson and Andrew Jackson, "High-Frequency
Performance Monitoring," Journal of Portfolio Management, Fall
2001, pp. 33-43 (519kb). Also
here.
This excellent paper warns that basing a judgment of an investment manager's
relative "skill" on very short-term results increases the probability of
incorrectly judging an unskilled manager to have skill and, just as
badly, increases the probability of incorrectly judging a skilled manager to
NOT have skill.

Eugene F. Fama and Kenneth R. French, "Luck
versus Skill in the Cross Section of Mutual Fund Returns," Journal of
Finance,
October 2010, pp. 1915-1947. This paper uses an approach similar to
that used in the Murphy paper below, only using more real-world data.
This paper takes real data of mutual fund performance (i.e., which shows a
range of estimated alphas) and deliberately adjusts each fund's performance
data set so that its alpha is zero (i.e., its estimated alpha is subtracted
from each data point). Thus, each synthetic fund now has a known alpha
exactly equal to zero. This data base of synthetic zero alpha funds
was then used to generate 10,000 monthly returns using a bootstrap sampling
approach (with replacement). These monthly returns yielded an example
of what might be expected in real life if it were true that the true alphas
of each fund were, in fact, exactly equal to zero. The paper found
that the distribution of realized alphas from the simulation (i.e., where it
was known that the true alpha was zero -- that any resulting apparent alpha
was merely due to good luck) was similar to that found for actual funds.
In fact, if anything, the distribution of alpha estimates for real funds
showed that the actual alpha of real funds was probably negative, but no
better than approximately zero. Thus, good alpha estimates for real
funds were consistent with what would be expected through luck alone (i.e.,
suggesting that good results of actively managed funds are due to good luck
and not skill).

Eugene F. Fama and Kenneth R. French, "Luck
versus Skill in Mutual Fund Performance," Fama/French Forum,
November 30, 2009. This is a slightly less technical
description of the above Fama/French paper. The paper uses a
simulation to show that the actual alphas of actively managed funds are no
better than, and probably worse than, those expected purely through good
luck alone (i.e., worse than they would be through simulations with alphas
pre-programmed to be exactly zero). This suggests that apparently good
performance of actively managed funds is generally consistent with what
would be expected through luck alone (i.e., good performance should
generally be attributed to good luck and not to skill). However, this
is not evident from merely evaluating an active manager's performance, even
if it is adjusted for risk (e.g., a calculated "alpha").

S.P. Kothari and Jerold B. Warner, "Evaluating
Mutual Fund Performance," Journal of Finance, October 2001, pp.
1985-2010. An earlier version is available
here. An interesting study. They generated synthetic
stock portfolios, simulated their operating as mutual funds and then analyzed
their performance as though they were mutual funds. "... standard mutual
fund performance measures are unreliable and can result in false inferences.
It is hard to detect abnormal performance when it exists, particularly for a
fund whose style characteristics differ from those of the value-weighted
market portfolio." In particular, the study found that it is easy to
detect abnormal performance and market-timing ability when none exists.

J. Michael Murphy, "Why No One Can Tell Who's
Winning," Financial Analysts Journal, May/June 1980, pp. 49-57.
This outstanding paper demonstrates why it is so hard to identify truly skilled
investment managers (assuming that they exist at all). The author
created 100 synthetic investment managers, each with a predetermined
probability distribution of returns. 10 were pre-programmed to be more
likely to outperform the market, 10 were pre-programmed to underperform the
market, and 80 were pre-programmed to average the market returns. He
simulated ten years of returns. The
results were stunning: while the outperformers as a group dramatically
outperformed both the random performers and the underperformers, the top two
funds, four of the top five, and six of the top nine best performing funds
over the simulated ten year period were random performers (i.e., those who
were preprogrammed to have an expected return equaling the market return). In other words, two
managers with absolutely no skill got lucky to an extent which allowed them to outshine
one hundred percent of the managers who definitely had skill
— OVER A TEN YEAR PERIOD. This really drives home how
dangerous it is to assume skill based on performance measurements over any "short" time period. "Given
enough time, the outperformers should produce results significantly superior
to those of the random performers. But the time required undoubtedly
exceeds the lifetimes of the managers being measured."

When evaluating the performance of a mutual fund or other investment, one
must somehow adjust it for the relative riskiness inherent therein. There
are three primary means of doing so: the Jensen index, the Treynor index, and
the Sharpe Ratio. More recent, but less well known and used, are the
Sortino Ratio and the Upside Potential Ratio. Also, see the section on
Risk Measures and
Performance Evaluation.

Aswath Damodoran, "Estimating
Risk-Free Rates," NYU Stern School of Business (22kb).
Nearly all measures of risk-adjusted performance require estimation of a
"risk-free" return. This paper thoroughly discusses issues surrounding
estimating such a value.

Michael C. Jensen,
“The Performance of Mutual Funds in the Period 1945-1964,” Journal of
Finance, May 1968, pp. 389-416 (178kb). Also
here. Introduces "alpha,"
more commonly known as "Jensen's Alpha." This is a risk adjusted measure
of how much a particular investment's return exceeds that of some benchmark.

Franco Modigliani and Leah Modigliani,
"Risk-Adjusted Performance," Journal of Portfolio Management, Winter
1997, pp. 45-54. This paper introduces the measure popularly
known as M2 ("M-square"). M2 is a measure closely
related to the Sharpe Ratio. Its major benefit over the Sharpe ratio is
that, rather than being a dimensionless ratio, it states the result in terms
of percentage return, which is much more appealing and understandable by most
people. Co-written by a Nobel prize winner. Also, see the Modigliani article below.

Leah Modigliani, "Yes,
You Can Eat Risk-Adjusted Returns," Morgan Stanley U.S. Investment
Research, March 17 1997 (36kb). An excellent discussion of the M2
("M-square") measure of risk-adjusted performance. This is a much easier-to-read discussion than the Modigliani/Modigliani paper above.

Auke Plantinga, Robert van der Meer, and Frank A.
Sortino, "The
Impact of Downside Risk on Risk-Adjusted Performance of Mutual Funds in the Euronext Markets," Social Science Research
Network working paper number 277352, July 21 2001 (171kb). This
excellent paper concludes that Upside Potential Ratio is a better measure of
risk-adjusted performance than the Sharpe Ratio. However, it goes on to
note that this is only the case where return distributions are skewed (i.e.,
unsymmetrical) and that the mutual funds they analyzed seemed to have
symmetrical returns, meaning that the (easier to calculate) Sharpe Ratio
should generally give reliable results.

Jeffrey H. Rattiner, "Adjust
for Comfort: Keep your Clients Comfortable by Matching Risk-Adjusted Returns
with their Risk-Tolerance Profiles — The Quantifiable Way," Financial
Planning, May 1 2001, pp. 111-113. A very readable summary
description of the three most popular measures for risk-adjusted performance.

A.D. Roy, "Safety First and the Holding of Assets,"
Econometrica, July 1952, pp. 431-450. This may have been
the first paper to suggest the idea of a "minimal acceptable return" as part
of the measurement of risk-adjusted return. Roy suggested
maximizing the ratio "(m-d)/σ", where m is
expected gross return, d is some "disaster level" (a.k.a., minimum
acceptable return) and σ is standard deviation of returns. This
ratio is just the Sharpe Ratio, only using minimum acceptable return instead
of risk-free return in the numerator!

William F. Sharpe, "Mutual
Fund Performance," Journal of Business, January 1966, pp.
119-138. This paper first introduced what would eventually be
termed "the Sharpe Ratio."
Written by a Nobel Prize winner.

William F. Sharpe, "The
Sharpe Ratio," Journal of Portfolio
Management, Fall 1994, pp. 49-58. An excellent discussion of
one of the most popular measures of risk-adjusted investment performance.
Written by a Nobel Prize winner.

Frank A. Sortino,
Robert van der Meer, Auke Plantinga, and Hal Forsey, "Upside
Potential Ratio," Pension Research Institute, 1998. This
article describes the "Upside Potential Ratio," another means of measuring
risk-adjusted return. In order to perform the calculation, you must
define a Minimum Acceptable Return (MAR). The Upside Potential Ratio
assumes that the investment objective is to maximize the expected
return above the MAR, subject to the risk of falling below the MAR.
It is calculated by dividing the upside potential by the downside deviation.

Jack L. Treynor,
“How to Rate Management Investment Funds,” Harvard Business Review,
January/February 1966, pp. 63-74. While not used as often as the
Jensen Index or the Sharpe Ratio, the "Treynor Index" introduced here is
sometimes used for evaluating risk-adjusted performance.

"Portfolio Insurance" refers to a strategy for ensuring that a portfolio's
value never falls below some "floor" value. Among the approaches are
Options-Based Portfolio Insurance (OBPI) and Constant Proportion Portfolio
Insurance (CPPI).

Hayne E. Leland, "Who Should Buy Portfolio
Insurance?," Financial Analysts Journal, May 1980, pp. 581-594. This
article describes the development of the idea of Options-Based Portfolio
Insurance (OBPI). Basically, it followed directly from the derivation
of the famous Black-Scholes option pricing formula.

Hayne E. Leland and Mark Rubinstein, "The
Evolution of Portfolio Insurance," Dynamic Hedging: A Guide to
Portfolio Insurance, edited by Don Luskin 1988. This
article describes the development of the idea of Options-Based Portfolio
Insurance (OBPI). Basically, it followed directly from the derivation
of the famous Black-Scholes option pricing formula.

In addition to the articles below, for a good introduction to the Prudent
Investor Rule, see here.

Robert J.
Aalberts and Percy S. Poon, "The New Prudent Investor Rule and the Modern
Portfolio Theory: A New Direction for Fiduciaries," American Business Law
Journal, Fall 1996, pp. 39-71. A good discussion of the Prudent
Investor Rule.

Frederic J.
Bendremer, "Modern Portfolio Theory and International Investments under the
Uniform Prudent Investor Act," Real Property, Probate and Trust Journal,
Winter 2001, pp. 791-809. "Inclusion of international investments within
a fiduciary portfolio is appropriate and may indeed be required under the UPIA
[Uniform Prudent Investor Act] and MPT."

Edward C. Halbach, Jr., "Trust
Investment Law in the Third Restatement," Real Property, Probate and Trust
Journal, Fall 1992. A good discussion of the background behind
many of the trust issues covered in the Third Restatement (including the Prudent
Investor Rule). Written by the recorder of the proceedings.

Real Estate Investment Trusts (REITs) are basically companies whose business
is to own and operate Real Estate (at least that is what equity REITs do
— there are other types). The company stock
trades just like any other stock. Equity REITs are an excellent means to
get exposure to the Real Estate asset class.

Hsuan-Chi Chen, Keng-Yu Ho, Chiuling Lu, Cheng-Huan
Wu, "Real Estate Investment Trusts," Journal of Portfolio Management,
September 2005, pp. 46-53. This paper concludes that Equity REITs
have significant diversification benefit. On the other hand, mortgage
REITs do not: "... there is no role for mortgage REITs in the optimal
portfolio."

Joseph Gyourko and Donald B. Keim, "What Does the
Stock Market Tell Us About Real Estate Returns?," Journal of the American
Real Estate and Urban Economics Association, Fall 1992, pp. 457-485.
This paper concludes that equity REIT performance is correlated with changes
in real estate valuation, but equity REIT performance leads
corresponding changes in real estate valuation. In other words, if you
wanted to predict real estate valuation trends, it would be useful to note
equity REIT stock performance trends in the recent past. This suggests
that equity REIT holdings might be redundant with other real estate holdings
from an asset allocation perspective. So if you already hold large
amounts of real estate, you may not want to buy equity REITs.

Joseph Gyourko, "Real
Estate Returns in the Public and Private Markets: A Reexamination Following
the Rise of Equity REITs," TIAA-CREF Institute Working Paper 17-100-103,
October 13 2003 (204kb). For a discussion of this paper, see
here. This study updates the Gyourko/Keim 1992
study above and finds that the conclusions of the earlier paper still hold.

Susan Hudson-Wilson, Frank J. Fabozzi, and Jacques
N. Gordon, "Why Real Estate?," Journal of Portfolio Management,
Special Real Estate Issue, 2003, pp. 12-25. "We have seen that
real estate is a risk reducer in a low- to moderate-risk portfolio, and
has no role in a very highly risk-tolerant portfolio. We have also seen that
real estate is not reliable as a producer of the highest absolute returns but
that stock equities are better suited for that task. We have learned that
private equity real estate is an effective partial hedge against inflation,
although different property types deliver different degrees of inflation
hedge. We have seen that there is a lot of real estate, so a decision to leave
real estate out of a portfolio altogether is a dramatic one and requires a
rationale in itself. Finally, we have seen that real estate is an excellent
generator of cash yield, outperforming stocks and bonds."

Stephen R. Mull and Luc A. Soenen, "U.S. REITs as an
Asset Class in International Investment Portfolios," Financial Analysts
Journal, March/April 1997, pp. 55-61. This paper points out that
REITs are an excellent hedge against inflation.

Yaniv Tepper and Paul E. Adornato, "Appealing
Tax Considerations often Overlooked for Individual REIT Investors,"
Journal of Financial Planning, March 2000, pp. 98-102. Also
here. While
we generally recommend REITs be used only in tax-exempt portfolios, this
article describes a little-known tax benefit of having them in taxable
accounts: a portion of REIT dividends is considered a "return of
capital" and is not taxed the same as other dividends.

Rebalancing refers to periodically restoring a portfolio's asset allocation
to its target proportions. If you don't rebalance, the portfolio naturally
drifts from its target allocation. This either increases or decreases your
portfolio's risk profile, neither of which is desirable (assuming that the risk
profile is appropriate for the investor in the first place).

Robert D. Arnott and Robert M. Lovell, Jr., "Rebalancing:
Why? When? How Often?," Journal of Investing, Spring 1993, pp. 5-10
(52kb). An excellent discussion of the benefits of rebalancing
and a comparison of various rebalancing routines.

William J. Bernstein, "The
Rebalancing Bonus," Efficient Frontier,
Fall 1996. This paper presents a formula which quantifies the
benefits of rebalancing.

William J. Bernstein, "Case
Studies in Rebalancing," Efficient Frontier, Fall 2000.
"The returns differences among various rebalancing strategies are quite small
in the long run."

Gerald Buetow Jr., Ronald Sellers, Donald Trotter,
Elaine Hunt, and Willie A. Whipple J., "The Benefits of Rebalancing: Worth the
Effort," Journal of Portfolio Management, Winter 2002, pp. 23-32.
This paper's principal contribution is that if one uses a "threshold" to
determine when to rebalance, five percent of the target allocation seems
optimal (e.g., if the target allocation of an asset class is 30%, then
rebalance any time it gets out of the range 28.5% to 31.5%).

Robert M. Dammon, Chester S. Spatt, and Harold H.
Zhang, "Capital
Gains Taxes and Portfolio Rebalancing," TIAA-CREF Institute research
dialogue, March 2003, pp. 1-15 (192kb). The authors capture
the trade-off over the investor’s lifetime between the tax costs and
diversification benefits of trading. They find that the investor’s incentive
to re-diversify the portfolio declines with the size of the capital gain and
the investor’s age. Unlike conventional financial advice, the reset of the
capital gains tax basis and the resulting elimination of the capital gains tax
liability at death, suggests that the optimal equity proportion of the
investor’s portfolio increases as he ages.

Christopher Donohue, "Optimal Portfolio Rebalancing
with Transaction Costs," Journal of Portfolio Management, Summer 2003,
pp. 49-63. "Academic research has proven the optimality of a
no-trade region around an investor's desired asset proportions so that trading
occurs only when asset proportions drift outside this region, and then only to
bring proportions back to the boundary of the no-trade region, not to the
target proportions." Note that the preceding quote only applies to
proportional rebalancing fees (e.g., capital gains taxes).

"Aside from avoiding excessive trading, there are no optimal rebalancing
rules that will yield the highest returns on all portfolios and in every
period. The good news for investors is that without an optimal way to
rebalance, the burden of producing returns through optimal rebalancing is
lifted. Return generation is again the responsibility of the market, which
sets prices to compensate investors for the risks they bear. The primary
motivation for rebalancing should not be the pursuit of higher returns, as
returns are determined through the asset allocation, not through rebalancing.
The bad news, of course, is that there is no easy one-size-fits-all
rebalancing solution.

Rebalancing decisions should be driven by the need to maintain an allocation
with a risk and return profile appropriate for each investor. The optimal
rebalancing strategy will differ for each investor, depending on their unique
sensitivities to deviations from the target allocation, transaction frequency,
and tax costs."

Seth J. Masters, "Rules
for Rebalancing," Financial Planning, December 2002, pp. 89-93.
This article also appeared in Journal of Portfolio Management, Spring
2003, pp 52-57.
An extremely well-written authoritative article on the subject. There is
also an excellent sidebar by John Thompson at this link called "What History
Tells Us: 'Tis Better to Have Rebalanced Regularly Than Not at All."

When sensible,
execute trades to generate tax losses that can then be used to offset any
capital gains generated by rebalancing trades.

Be patient and wait
until eligible for long-term capital gains treatment.

If taxable and
tax-deferred accounts are both allocated toward the same goal, have the
tax-deferred account bear as much of the rebalancing load as possible."

Bert Stine and John Lewis, "Guidelines
for Rebalancing Passive-Investment Portfolios," Journal of Financial
Planning, April 1992, pp. 80-86. Also
here. "... in most cases, the
investor would be advised to rebalance only when the portfolio reaches a
predetermined level of risk exposure rather than to make the adjustment on a
calendar basis."

Yesim Tokat, "Portfolio
Rebalancing in Theory and Practice," Vanguard Investment Counseling &
Research, February 15 2006. This also appeared in the Journal of
Investing, Summer 2007, pp. 52-59. A good discussion of the
issue.

Cindy Sin-Yi Tsai, "Rebalancing Diversified
Portfolios of Various Risk Profiles," Journal of Financial Planning,
October 2001, pp. 104-110. Also
here. "Portfolios should be periodically
rebalanced. This paper shows that neglecting rebalancing produces the
lowest Sharpe ratios." "However, ... it does not matter much which
[rebalancing] strategy they adopt."

Ian Ayres and Barry J. Nalebuff, "Diversification
Across Time," Yale Law & Economics Research Paper No. 413,
Oct 4, 2010. This outstanding paper discusses the idea of
spreading one's stock exposure more evenly across their lifetime, which
should then reduce the riskiness surrounding the ending wealth.
Here's an excellent website
where the authors discuss this idea.
Here's the outstanding book where they elaborate in depth on this idea.

Leonard E. Burman, William G. Gale, and David
Weiner, "The
Taxation of Retirement Saving: Choosing Between Front-Loaded and Back-Loaded
Options," Brookings Institution, May 2001 (102kb). This paper also
appeared in National Tax Journal, Vol 54 No. 3 2001, pp. 689-702.
"Despite the fact that effective tax rates on [traditional]
IRAs were generally negative, many investors would have benefited from
contributing to a Roth instead of a traditional IRA over the 1982-95 time
period because of the larger effective sheltering provided by a Roth IRA."

Frank Caliendo and W. Cris Lewis, "Myths
and Truths of IRA Investing," Journal of Financial Planning,
October 2002, pp. 86-94. This excellent paper definitively
answers two questions: 1) How do you choose between investing in a taxable
account and a Traditional IRA? 2) How do you choose between investing in
a Traditional IRA and a Roth IRA?

Jennifer Huang, "Taxable
and Tax-Deferred Investing: A Tax-Arbitrage Approach,"
Review of Financial Studies, September 2008, pp. 2173-2207. Also
here. This paper's conclusions are dependent on
whether a person anticipates needing access to assets before age 59.5.
If they do anticipate such a need (that is, they have a liquidity need), then
it is prudent to locate taxable bonds in both taxable and tax-deferred
accounts. If they do not anticipate such a need, then investors always
should prefer bonds to be in tax-deferred accounts. The bottom line is
that, in the absence of liquidity needs, you should put the investments with
the highest dividend payout ratio in the tax-deferred account (an investment's
dividend payout ratio is defined as its dividend yield divided by its total
return).

James M. Poterba, John B. Shoven, and Clemens Sialm,
"Asset
Location for Retirement Savers," NBER Working Paper 7991, November 2000
(603kb). Also "Private Pensions and Public Policies", The Brookings
Institution, 2004, pp. 290-331. Also
here,
here and
here. "... a risk averse retirement accumulator would
historically have fared better with an index [equity] fund, and an asset
location strategy that held this fund in a taxable setting, than with a
randomly chosen actively managed [equity] fund ..." This paper suggests that
if you must have a tax-inefficient actively managed stock fund, it is best
kept in a tax-exempt account with tax-exempt bonds in a taxable account.
However, it suggests that a superior strategy would be to instead use
tax-efficient passively managed stock funds in the taxable account and taxable
bonds in the tax-exempt account. In short, they advocate locating the
least tax-efficient investments in the tax-exempt account.

William Reichenstein, "Savings
Vehicles and the Taxation of Individual Investors," Journal of Private
Portfolio Management, Winter 1999 (88kb). "When saving for
retirement, the most important consideration is the tax structure. In
this case, the better choice between two savings vehicles is the one that
produces the greater after-tax ending wealth."

John B. Shoven and Clemens Sialm, "Asset
Location in Tax-Deferred and Conventional Savings Accounts,"
Journal of Public Economics, 88 2003, pp. 23-38. Also
here
and
here. "... assets with high tax rates should be located
in the tax-deferred environment. In particular, taxable bonds should be
held in the tax-deferred environment, whereas tax-exempt municipal bonds
should be held in the taxable environment. Stocks can be located in
either environment depending on the tax-efficiency of the stock portfolios."

John J. Spitzer and Sandeep Singh, "Extending
Retirement Payouts by Optimizing the Sequence of Withdrawals,"
Journal of Financial Planning, April 2006 (795 kb). The most
important contribution of this article is its insight in answering the
following question: if you have both a traditional IRA and a Roth IRA, what is
the optimal sequence of tapping those accounts in retirement? On the one
hand you might think that you should take the traditional IRA out first, thus
maximizing the tax-free benefit of the Roth IRA. On the other hand, you
might think that you should use the Roth IRA first, thus delaying payment of
taxes associated with the traditional IRA as long as possible. It turns
out that the optimal approach is a hybrid of the two: each year, use the
traditional IRA as necessary to get to the top of a low tax bracket -- then
supplement that as necessary with Roth IRA withdrawals. This gets you
the best of both worlds: the traditional IRA is taxed at a low marginal rate
and the Roth withdrawals allow you to avoid a high marginal rate.

"Rousey
v. Jacoway; 03-1407," United States Supreme Court, April 4 2005.
This Supreme Court decision confirms that IRA accounts are subject to the same
bankruptcy protections that 401(k) and other ERISA plans are subject to.

Reversion to the mean is the phenomenon (discovered by Charles Darwin's
cousin, Sir Francis Galton (1822-1911)) whereby a stock's average performance
(or a mutual fund's, or many other non-investing statistics) tend to become more
average (i.e., less extreme) over time. If true, this implies that recent
good performers are perhaps somewhat more likely than average to be below
average performers in the future (and vice versa). This idea is supported
by much of the research. Also, see Mutual Fund Persistence.

Bob Bronson, "Reversion-to-the-mean is not a glide path phenomenon,"
December 14 2000. This commentator
notes that mean reversion doesn't mean that an investment's future performance
is likely to gradually approach some asymptote. Rather, it is likely to
cycle to the other extreme (i.e., good performance is likely to be followed by
bad performance, and vice versa), which over time will cause the average
performance to approach some asymptote.

Werner F.M. De Bondt and Richard Thaler, "Does the
Stock Market Overreact?," Journal of Finance, July 1985, pp. 793-805.
This paper suggests a behavioral explanation for observed mean reversion:
overreaction. It suggests that "loser stocks" tend to subsequently
outperform "winner stocks" because the "loser stocks" became loser stocks to
an extent that exceeded rational justification (i.e., they were previously
bid down lower than justified by rational expectations). Likewise, the
"winner stocks" were previously bid up higher than justified by rational
expectations. Over time, those expectations become more rational and the
overreactions disappear, causing a reversion to the mean.

Eugene F. Fama and Kenneth R. French, "Permanent and
Temporary Components of Stock Prices," Journal of Political Economy, 96
1988, pp. 246-273 (1.8mb). Also
here. "A slowly mean-reverting component of stock
prices tends to induce negative autocorrelation in returns." "In tests
for the 1926-1985 period, large negative autocorrelations for return horizons
beyond a year suggest that predictable price variation due to mean reversion
accounts for large fractions of 3-5 year return variances. Predictable
variation is estimated to be about 40 percent of 3-5 year return variances for
portfolios of small firms. The percentage falls to about 25 percent for
portfolios of large firms."

Eugene F. Fama and Kenneth R. French, "Forecasting
Profitability and Earnings," Journal of Business, 73(2) 2000, pp.
161-175. This paper looks at mean reversion of a corporation's
earnings. "Standard economic arguments say that in a competitive
environment, profitability is mean reverting. Our evidence is in line
with this prediction."

Jonathan W. Lewellen, "Temporary
Movements in Stock Prices," MIT Sloan School Working Paper, May 2001.
Also available
here
(105kb). "Mean reversion in stock prices is stronger than
commonly believed. ... The reversals are also economically significant. The
full-sample evidence suggests that 25% to 40% of annual returns are temporary,
reversing within 18 months. The percentage drops to between 20% and 30% after
1945. Mean reversion appears strongest in larger stocks and can take several
months to show up in prices."

Burton G. Malkiel, "Models
of Stock Market Predictability," Journal of Financial Research,
Winter 2004, pp. 445-459 (159kb). This study finds that, while
there appears to exist some reversion to the mean behavior, "... there is
no evidence of any systematic inefficiency that would enable investors to earn
excess returns." In other words, market timing models aren't likely
to be fruitful.

A.D. Roy, "Safety First and the Holding of Assets,"
Econometrica, July 1952, pp. 431-450. This may have been
the first paper to suggest a downside risk measure. Roy suggested
maximizing the ratio "(m-d)/σ", where m is
expected gross return, d is some "disaster level" (a.k.a., minimum
acceptable return) and σ is standard deviation of returns. This
ratio is just the Sharpe Ratio, only using minimum acceptable return instead
of risk-free return in the numerator!

W. Van Harlow, "Asset Allocation in a Downside-Risk
Framework," Financial Analysts Journal, September/October 1992, pp.
28-40. An outstanding article on use of downside risk measures
(e.g., downside variance or downside deviation). Downside risk turns out
to be a superior risk measure (i.e., better than standard deviation) in
circumstances where the return distribution is not symmetrical and/or a
"Minimal Acceptable Return" can be defined.

Susan Wheelock, "Risky
Business," Plan Sponsor, September 1995. An excellent,
very readable description of downside risk. All of the performance
measures discussed in the Performance
Evaluation section are risk-adjusted measures. The
Sortino Ratio and the Upside Potential Ratio use downside risk as their risk
measure.

Most US workers are entitled to Social Security Retirement Benefits when they
get old enough. This benefit can be substantial and should be considered
as part of retirement planning. A strong case can be made not only to
include the income in future cash-flow plans, but to include the present value
of future Social Security benefits as a current asset in your portfolio when
doing asset allocation (it is closer to an
inflation protected bond than anything else).

Lynn Brenner, "'Reset'
Social Security and collect more ," InvestmentNews IN retirement,
March 12, 2009. This article discusses an interesting option.
You start taking Social Security retirement benefits sometime before age 70.
Then, at age 70, you can pay back the benefits you received (without any
interest) and start taking a higher level of benefits -- for the rest of your
life -- at age 70. Apparently it is possible to also recover income
taxes paid on those benefits you are paying back. An interesting option
for those who, at age 70, feel that their health is such that they (or their
spouse) expects to be fairly long-lived.

Kirsten A. Cook, William W. Jennings, and William
Reichenstein, "When Should you Start your Social
Security Benefits?," AAII Journal, November 2002. "...
assuming life expectancies are average and benefits are not reduced by the
earnings test, the benefits schedule is actuarially fair for single males and
females."

John H. Detweiler, “A Note on the 62-65 Social
Security Decision,” National Estimator, Spring 1999, pp. 39-42.
"If one does not need the cash at age 62, deciding when to receive the Social
Security retirement benefit is just another investment decision and should be
so treated."

Joseph P. McCormack and Grady Perdue, "Optimizing
the initiation of Social Security benefits,"
Financial Services Review, Volume 15 (2006), pp. 335-348.
"Early initiation of benefits is the correct course of action for
individuals with lower life expectancies. However, delayed initiation of
benefits may often be the correct course of action for a single person with a
long life expectancy or for a married male who is the higher income-earning
spouse."

Robert Muksian, "The
Effect of Retirement Under Social Security at Age 62," Journal of
Financial Planning, January 2004, pp. 64-71. "Unless early
retirement is 'mandated' due to health reasons, it appears one should wait
until normal retirement age or later to begin collecting Social Security."

William Reichenstein and William Jennings,
Integrating Investments & The Tax Code (John Wiley & Sons, Inc, 2003), pp.
169-212. An excellent discussion of exactly how to calculate the
present value of future Social Security benefits.

Clarence C. Rose and L. Keith Larimore, "Social
Security Benefit Considerations in Early Retirement,"
Journal of Financial Planning, June 2001, pp. 116-121. Also
here.
"... the economic value of beginning Social Security at age 62 for men is
greater than waiting for full retirement. For women, the economic value of
waiting for full retirement is slightly greater than early retirement for
those attaining age 62 in the year 2000." "The differences in the
economic values do not appear to be significant enough in any of the
situations to be the major factor influencing the decision as to when to begin
Social Security benefits."

John J. Spitzer, "Delaying
Social Security payments: a bootstrap,"
Financial Services Review, Volume 15 (2006), pp. 233-245.
"This paper reconciles previous research outcomes and explains why
prior studies offer conflicting recommendations regarding the decision to
delay Social Security payments. ... When life expectancy and realistic
investment returns are incorporated into the analysis, there are few
circumstances that warrant postponing Social Security payments for early
retirees."

Thomas G. Walsh, "Spousal
and Survivor Elections of Normal Versus Early Retirement Benefits,"
TIAA-CREF Institute, July 2002. "The breakeven after tax interest
rates to justify an early retirement election for a survivor are lower than
for a worker or spouse. This means that a survivor could be more
inclined from a financial perspective to elect early retirement benefits than
a worker or spouse, all other factors being equal."

Thomas G. Walsh, "Electing
normal retirement social security benefits versus electing early retirement
social security benefits," TIAA-CREF Institute, July 2002.
"In most situations, persons can make a decision about when to begin Social
Security benefits that are unrelated to the potential for a slight financial
advantage for one option versus another." The author goes on to comment
that a person in poor health, and/or who has dependent children should prefer
early benefits and that wealthy individuals who don't require the cash flow
may prefer waiting as long as possible to begin.

Survivorship bias refers to the phenomena whereby the past records of
existing mutual funds are examined to determine various trends. The
problem lies in the fact that you are only examining the past records of
currently existing funds — funds which ceased existence
in the past are not included in your data. This tends to cause one to
(falsely) conclude that the average mutual fund has performed better than is
actually the case (because the funds which cease to exist and are therefore
removed from the sample universe tend to be the poor performers). Due to
survivorship bias, it is actually possible to (falsely) conclude that the
average dollar invested in mutual funds performed better than average! Also, see
mutual fund persistence.

Mark M. Carhart, Jennifer N. Carpenter, Anthony W.
Lynch, and David K. Musto, "Mutual
Fund Survivorship," Review of Financial Studies, Issue 5 2002,
pp. 1439-1463 (371kb). Also
here. This paper shows that mutual fund
survivorship bias is about 0.07% over one year periods, but about one percent
for periods of 15 years of longer (in other words, if one studied mutual fund
performance over a 15 year period, the annual return of the average fund
dollar would be overstated by about one percentage point annually). An
excellent comprehensive analysis of survivorship issues in mutual fund
performance studies.

Stephen J. Brown, William N. Goetzmann, and Stephen
A. Ross, "Survival," Journal of Finance, July 1995, pp. 853-873
(1.9mb).
This paper concludes that survivorship bias increases "the probability of
false rejection of temporal independence." In other words, survivorship
bias tends to cause one to conclude that phenomena such as mutual fund
persistence exists, when it may not.

Synthetic indexing refers to a strategy of replicating an index by buying
futures (or derivatives) on an index, rather than buying the underlying
securities making up the index. Implicit in the price of a futures
contract is an assumed interest rate covering the period from purchase of the
contract to the contract expiration date. The futures themselves are
typically a relatively small portion of the portfolio (enough futures are bought
to simulate full investment in the index). An even smaller portion of the
portfolio is set aside in very short-term treasuries as collateral. The
remaining cash is typically invested in a bond portfolio with a goal of trying
to exceed the interest rate assumed in the pricing of the futures contract. If the
bond portfolio can earn a better risk-adjusted return than the interest rate
implicit in the futures price, it is possible to have better risk-adjusted
returns than the index (before fees).

The above discussion describes synthetic indexing. There are several
other means of "enhanced" indexing.

Joanne M. Hill and Humza Naviwala, "Synthetic and
Enhanced Index Strategies using Futures on U.S. Indexes," Journal of
Portfolio Management, May 1999, pp. 61-74. A good overview of
several variations on this investment strategy.

Todd Miller and Timothy S. Meckel, "Beating Index
Funds with Derivatives," Journal of Portfolio Management, May 1999, pp.
75-87. A good overview of several variations on this investment
strategy.

Mark W. Riepe and Matthew D. Werner, "Are Enhanced
Index Funds Worthy of their Name?," Journal of Investing, Summer 1998,
pp. 6-15. This paper investigates whether synthetic index funds
have been successful in exceeding the returns of their target index. It
finds that two of eight such funds did so during the period studied.

Anybody who has investments in a taxable account (i.e., stocks, bonds, or
mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be
concerned about minimizing their tax burden. Tax loss harvesting is an
important means of doing so. Also, see the section on
Tax Managed Investing.

Andrew L. Berkin and Jia Ye, "Tax Management,
Loss Harvesting, and HIFO Accounting," Financial Analysts Journal,
July/August 2003 pp. 91-102. "Our findings show that no matter
what market environment occurs in the future, managing a portfolio in a
tax-efficient manner gives substantially better after-tax performance than a
simple index fund [i.e., a buy and hold routine], both before and after
liquidation of the portfolio."

George M. Constantinides, "Optimal
Stock Trading With Personal Taxes," Journal of Financial Economics,
13 - 1984, pp. 65-89 (1.2mb). This paper suggests that it may be
beneficial to realize long term gains in order to increase the possibility of
realizing short-term losses in the future (which are worth more if short term
capital gains tax rates are higher than long-term capital gains rates).
The Dammon/Spatt paper below elaborates on this point.

Robert M. Dammon, Kenneth B. Dunn, and Chester S. Spatt, "A
Reexamination of the Value of Tax Options," Review of Financial Studies, Fall 1989, pp.
944-972 (307kb). This paper builds on the Constantinides paper
above. It finds that the value of realizing long-term gains (in order to
"reset the clock" for prospective realization of additional short term losses)
has less value than Constantinides suggested.

Robert M. Dammon and Chester S. Spatt, "The
Optimal Trading and Pricing of Securities with Asymmetric Capital Gains Taxes
and Transaction Costs," Review of Financial Studies, Fall 1996, pp.
921-952 (327kb). This paper plumbs the question of exactly at
what point capital losses ought to be harvested (the "Asymmetric Capital
Gains" refers to a situation where long-term capital gains are taxed at a
lower rate than short term gains). The optimal point at which to harvest
losses depends on several variables: the level of transaction costs, the
volatility of the security in question, and the time remaining in the "short
term region" until capital gains become classified as "long term gains."

Anybody who has investments in a taxable account (i.e., stocks, bonds, or
mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be
concerned about minimizing their tax burden. Taxes are just another type
of investing expense that ought to be prudently minimized. Also, see the
sections on Dividends and
Tax Loss Harvesting.

Frank Armstrong, "New
Generation of Tax Managed Funds," Investor Solutions,
April 8 2002. This article discusses the most tax-efficient
passive funds available, which not only manage to minimize capital gains
distributions, but also dividend distributions. The author doesn't
mention it, but Vanguard has three such funds, in
addition to several at DFA.

Joel M. Dickson and John B. Shoven,
"A Stock Index Mutual Fund Without Net Capital Gains Realizations," NBER Working Paper number 4717,
April 1994. Also
here
and here. This paper showed that a tax-managed passive mutual
fund was feasible. For non-taxable investors, such a fund would fair
about as well as a non-tax-managed alternative during the period studied.
For taxable investors, there would be a definite significant advantage with
the tax-managed fund.

Joel M. Dickson, John B. Shoven, and Clemens Sialm,
"Tax
Externalities of Equity Mutual Funds," National Tax Journal,
September 2000, pp. 607-628 (139 kb). Also
here. This paper suggests that
tax externalities (i.e., the fact that net redemptions in a mutual fund
adversely affect shareholders while net purchases benefits them) have a
dramatic tax effect on mutual funds. This effect can be managed both by
the mutual fund choosing a tax-favorable accounting method (i.e., HIFO instead
of FIFO) and a routine of selling losing investments instead of winning
investments. Implications for taxable investors are that, all other
things being equal, it might be beneficial to invest in a mutual fund that has
a tax-minimizing investing strategy and a tax-minimizing share accounting
method.

James P. Garland, "The Attraction of Tax-Managed
Index Funds," Journal of Investing, Spring 1997, pp. 13-20.
"The great majority of taxable investors are engaged in a foolish fancy.
They spend great time and effort trying to improve gross returns, when what
they should be doing is reducing costs." By "costs," the author
means primarily taxes, and, secondarily, commissions and investment management
fees. According to the paper, a typical actively managed fund needs a
2.63% annual alpha to break even on an after-tax basis with a tax-efficient
index fund.

Robert H. Jeffrey and Robert D. Arnott, "Is your alpha big enough to cover
its taxes?," Journal of Portfolio Management, Spring 1993, pp. 15-25
(134kb). In answer to the question posed in the title, "...
most managers' alphas are not big enough to cover their taxes." This
suggests that actively managed mutual funds don't increase returns enough to
compensate for the increased taxes their active management causes.

Merton H. Miller, "Do
Dividends Really Matter?," The University of Chicago
Graduate School of Business, Selected Paper #57. One strategy for
tax-management in a taxable portfolio is to avoid dividend-paying stocks.
This paper validates the idea that whether or not any particular stock pays
dividends is irrelevant to the investor (except that the dividend-paying
stocks are less tax-efficient). Written by a Nobel Prize winner.

William Reichenstein, "Tax
Efficient Saving and Investing," TIAA-CREF Trends and Issues,
February 2006, pp. 2-15. This excellent article discusses many
important means of investing in a tax-sensitive manner.

David M. Stein, "Tax
Advisor: Pay Now, or Later?," Investment Advisor, September 2004,
pp. 169-170. This excellent article discusses the trade-off
between realizing capital gains now vs. realizing them later at what is likely
to be a higher tax rate.

Variable Annuities are appropriate for almost nobody. Their high costs
generally dramatically outweigh the potential benefit of tax deferral except for
the lowest cost annuities for persons with investment time horizons of many
decades. However, if you are stuck in one, you ought to consider
getting out of your high cost VA by doing a tax-free 1035 exchange into one of
the excellent low-cost options at
TIAA-CREF or
Vanguard.

William J. Bernstein, "A
Limited Case for Variable Annuities," Efficient Frontier,
Summer 2001.
The author makes a VERY limited case for a small amount of Variable Annuities
in your portfolio IF (and only if) several important criteria are met.

"So, it’s clear that an annuity makes sense only if all four of the
following conditions are met:

The asset class is highly tax-inefficient.

The asset class’s expected return is significantly higher
than that of a comparable tax-efficient stock or bond expected return
after reducing it by the higher expenses incurred in the annuity.

The asset class is held for a long period of time, say for a child’s
trust.

You have run out of retirement vehicles in which to put this
investment."

Glenn Daily, "Just
say no to cash values," Glenndaily.com Information Services, Inc.,
May 1 2002. This fascinating article suggests an interesting
reason to use a Variable Annuity: in order to take advantage of a (currently
unrealized) loss in a whole life policy that you no longer want/need. If
you just cash in such a policy (i.e., one whose current surrender value is
less than the total premiums you've paid in to date), you don't have to pay
any taxes, but you lose the tax benefit of the loss (i.e., you can't use the
loss to offset other gains). But if you instead do a 1035 exchange into
a low-cost variable annuity, and then wait for the annuity to grow to the
level of the tax basis, and then cash in the variable annuity, you get to
avoid taxes on the gains between the current value and the (higher) basis,
which is inherited from the whole life policy.

Carolyn T. Geer, "The
Great Annuity Rip-Off," Forbes,
February 1998, p. 106. Also
here. This article exposes Variable Annuities as
the poor investments they usually are. Actually, that's not completely true
— they are the preferred choice for Variable Annuity salespeople (who make large
commissions on each sale).

Moshe Arye Milevsky and Kamphol Panyagometh,
"Variable Annuities versus mutual funds: A Monte-Carlo analysis of the
options," Financial Services Review, Vol 10 2001, pp. 145-161.
"... for the average cost variable annuity with 66 basis points of insurance
expenses, the risk-adjusted break even horizon can be as high as 30 years."
This paper concludes that the ability to harvest losses in taxable mutual fund
accounts substantially increases the breakeven period before a post-tax
variable annuity beats the taxable mutual fund.

William Reichenstein, "An Analysis of Non-Qualified
Tax-Deferred Annuities," Journal of Investing, Summer 2000, pp. 73-85.
This paper shows that average cost annuities are appropriate for virtually
nobody. Low cost annuities, however, may make sense for investors who
are in a lower tax-bracket in retirement and/or who have very long investment
time horizons.

William Reichenstein, "Who Should Buy a Nonqualified
Tax-deferred Annuity?," Financial Services Review, Spring 2002, pp.
11-31. In answer to the question posed in the title, there are
three classes of investors for whom low cost VAs may make sense:
those seeking protection from creditors, those with VERY long investment time
horizons, and those in the distribution stage of life who are interested in
annuitizing their investment portfolio distributions. He goes on to
point out that average or high cost VAs are appropriate for nobody.

Richard B. Toolson, "Tax-Advantaged Investing:
Comparing Variable Annuities and Mutual Funds," Journal of Accountancy,
May 1991, pp. 71-77. Toolson points out that the break even point
whereby the tax-deferral benefit of a variable annuity outweighs the VA's
extra costs may be as long as 50 years, or perhaps even longer.

Russ Wiles, "Tax
Law Cuts Appeal of Variable Annuities," Chicago Sun-Times,
July 14 2003. This article points out that the Jobs and Growth
Tax Relief Reconciliation Act of 2003 has made Variable Annuities even less
attractive than they were before.

Frank Armstrong, "Strategy
vs. Outcome," Investor Solutions, December 12 2002. A
good article pointing out the truth that a good strategy doesn't necessarily
produce good short term results and a bad strategy doesn't necessarily produce
bad short term results. Put somewhat differently, you can have good
results from poor strategy (if you are particularly lucky) and bad results
from good strategy (if you are particularly unlucky). Thus, you can't
necessarily judge the "goodness" of an investing strategy based on how it well
it performed (or would have performed) in the recent past.

Eugene Fama, Jr., "The
Error Term," Dimensional Fund Advisors, December 2001.
An excellent discussion of the types of random "tracking error" you should
expect in certain types of passive portfolios, in particular those of
tax-managed funds which also minimize dividends.

Merton H. Miller, "The
History of Finance," Journal of Portfolio Management,
Summer 1999, pp. 95-101. An excellent overview of many of the
leading innovations in financial economics. Written by a Nobel Prize
winner.

This web page contains the current opinions of Eric E. Haas at the time it is
written — and such opinions are subject to change
without notice. This web page is intended to serve two purposes:

To educate the public; and

To provide disclosure of Mr. Haas' opinions to prospective clients.
We believe that prospective clients are well-served by being made aware of
what they are buying — and what they are buying is advice
that is based on these opinions.

We believe the information provided here to be useful and accurate at the time
it is written.
Information contained herein has been obtained from sources believed to be
reliable, but is not guaranteed.

No investor should invest solely on the basis of information listed here.
Before investing, it is important to consult each prospective investment's
prospectus and consider both its risk/return characteristics and its effect on
your overall portfolio.

This information is not intended to be a
substitute for specific individualized tax, legal, or investment planning
advice. Where specific advice is necessary or appropriate, Altruist
recommends consultation with a qualified tax adviser, CPA, financial planner, or
investment adviser. If you would like to discuss the rationale or support
for any particular idea expressed on this web page, feel free to
contact us.